Income statement analysisJean-Claude Desnoyers
For a business owner, it is useful to know how to interpret the numbers in the various financial statements. These documents gather financial information available in a business. These financial statements are mostly produced annually. However, some businesses produce them on a monthly basis. When produced annually, it may be more difficult to analyze them in order to adjust the aim when something comes up. When produced on a regular basis, they can be analyzed to make decisions to increase the chances of achieving the business goals. This article will cover one of the financial statements, the income statement.
The income statement can be considered as the business history for a specified time period. It includes income earned during this period, expenses and profits. Generally, the income statement covers a whole year, but it is sometimes produced to cover a quarterly or monthly period.
Interesting ratios in the income statement
Most business owners want their business to grow. Successfully achieving that goal can be difficult. By analyzing the income statement, an entrepreneur can calculate several interesting ratios. Two of the relevant ratios to analyze are the gross and net profit margins before tax.
The gross margin is the difference between sales and cost of sales. For example, for a retail business, it is the difference between the purchase price of an item and its selling price.
For example, if the owner purchases an item at $ 60 and sells it for $ 100, gross profit is $ 40, which corresponds to 40% of sales. This margin is usually relatively stable, unless there are changes in the selling or purchase pricing policy.
Comparing this ratio with a typical business in the industry allows you to determine whether the is comparable to a similar business if the margin is not as good or better. If the margin is not as good, the owner may want to determine if there are specific reasons for this gap and whether it is possible or not to make adjustments to rectify the situation. A lower margin that can not be explained can also indicate a problem related to stolen goods, for example. By comparing this ratio in percentage of sales over several years, we can see if the business is relatively stable or if some adjustments are in order. A declining gross margin displayed as a percentage of sales can also indicate, for example, an increase in the competition.
The net profit before income tax calculation can help determine the business sustainability. Every industry has its standards. It is therefore difficult to establish the exact ratios that would represent a profit percentage to target. Knowing that the result of this ratio establishes the margin between making and losing money, I can say from experience that a minimum of 5% before tax as a net profit should be targeted. Note that we are referring to the true profitability and not necessarily the one presented in the income statement. For a business to be able to grow, it needs to have working capital and reserves. Whenever possible, it is necessary for the business to have some flexibility. The net profit before tax calculation result reflects the business’ financial capacity.
Overall, the financial statements turn out to be an effective management tool for a business owner. Ensuring close monitoring of expenses and income and knowing the business’ profits is the ultimate goal of most entrepreneurs. Lack of time can sometimes be an obstacle to verification and implementation of strategies. The monthly production of financial statements is a good solution to this challenge. Indeed, to have the business’ evolution on a monthly basis makes it easier to understand its strengths and weaknesses. Financial statement analysis raises awareness about improvements or changes that should be implemented. Good financial management is synonymous with being organized and effective. These are qualities that can be useful to ensure the longevity of the business.
If you want to learn more about the financial information analysis of a business, I invite you to read on the importance of financial information at the sale of a business and, more precisely, about balance sheet analysis.
Above all, do not hesitate to contact me if you need additional expertise to analyze your financial statements.