Analyzing the Income Statement

Undoubtedly, every business in America reviews their sales at some level. But are you getting the most out of your sales analysis, or is it a mundane process? Let’s examine your income statement and cover some approaches to evaluating your key accounts, and how you might look at your sales results differently.

Monthly Comparisons – Many companies look at their monthly sales in comparison to the prior month to determine trends. While that measurement can be a valuable indication of where your business might be heading, it likely doesn’t tell the whole story. One idea is to include a comparison of the same month in the prior year. This eliminates the bias of seasonality that we all deal with from month to month. Comparing month to month, quarter to quarter, and year to year with a “current year vs. prior year” approach provides you, as a manager, with a more accurate view of where your sales are heading.

Sales Growth – Another helpful tool you can easily create is a trailing 12-month spreadsheet detailing your sales growth from month to month over the past year. This provides you with an instant snapshot of the most relevant months of your business – the past 12. This tool also ignores the shortage of data when only using fiscal year analysis. For example, if you are reviewing sales in January or February of a fiscal year, analyzing your sales for the year would only include one or two months’ worth of data. But if you review the past 12 months, the information will be much more useful.

Down to the Details
As we work our way down the income statement, the next significant item is the cost of sales. Although there are several different interpretations of what constitutes the cost of sales, for our purposes, I’ll assume this includes direct materials, direct labor, and production overhead.

Direct materials and direct labor are areas where managers can exercise significant control if they understand them. For example, if you are selling $1 million per month in product and you figure out a way to reduce your percentage of direct materials to sales by 3 percent, you have just sent $30,000 to the bottom line. However, if you wish to manage direct materials or direct labor, you must measure them regularly. And the most effective way to measure them is to get into the details of the costs. When reviewing direct materials, your accounting and inventory systems must provide you with detail of individual materials consumed in the production cycle.

Multiple variables affect the costs of direct materials. Shop redos, the amount of wasted materials, overall material usage on jobs, and, of course, pricing, all factor into your overall costs and corresponding margins. Spend the necessary time to drill down into your material costs. As a result, you will gain a depth of information to help you manage your direct material costs.

Direct labor is also a very important expense to your business. Every accounting professor teaches that direct labor is a variable cost. As sales increase, your labor costs will increase proportionally. If sales go down, then you can cut labor costs to accommodate the lower sales for that period. But that’s just not true. In our industry, as well as many others, direct labor, in fact, behaves much more like a fixed cost than a variable one. How many of us have the luxury of reducing our work force in any significant way in preparation for a low month in sales? Unless you have a sales model with very even sales from month to month, this just doesn’t happen. In fact, the very next month might have a 15- to 20-percent bump in sales, which could create big problems if you cut your work force the month before. The best approach to managing your labor force is to determine the most efficient number of workers over the course of several months and balance that number, knowing that, as sales fluctuate, you will be overstaffed during some months and understaffed in others. The challenge is finding the most efficient number of employees to ensure profitability over several months’ time instead of trying to manage month to month.

One simple but effective way to evaluate direct labor can be accomplished by measuring sales per FTE (full-time equivalent employee). The formula you need divides total sales by the number of FTEs. For example, in a given month, if you sell $1 million and you have a total of 65 FTE employees, then that number is approximately $15,000 of sales per employee. That number by itself is meaningless, but when compared to several months or years of data, the numbers will help you determine the proper number of employees.

Compare the sales per FTE in some of your most profitable months and to the same numbers in months that had disappointing results. Soon, you will begin to see indications of what the correct number of employees might be. In our business, we have evaluated this measurement of labor for over 10 years and have found it to be a fairly accurate predictor of profitability with regards to the proportion of labor costs to sales.

By subtracting direct materials, direct labor, and production overhead from sales, you calculate gross margin. Gross margin represents profits (cash) generated from production. Just as you have a break-even sales number to focus on each month, you should also have a corresponding gross margin number you are trying to achieve. If you focus solely on sales, you are looking at your business with only one dimension. Getting sales in the door is obviously a crucial part of your business, but as you focus on your material and labor costs and control your overhead costs, your gross margin then becomes the key number in determining your monthly profits. Remember: The efficiency by which you produce your sales has more to do with profits than the amount of sales.

The Right Ratios
Use the following ratio to analyze your gross margins:
Gross Margin Ratio = Gross Margin / Sales

As you track this ratio on a regular basis and compare results from month to month and from year to year, you will identify and evaluate critical trends in the management of production resources as well as cash flow.

Below your gross margins are your sales and marketing expenses. These expenses are typically significant items on your income statement but are often overlooked when managing costs. Perhaps that is due to the fact that the majority of the costs are tied up in sales salaries and commissions and are essentially fixed in cost. However, some discretionary expenses such as marketing, advertising, entertainment, etc., should be tracked and reviewed regularly by management. The same goes for general and administrative expenses. Monthly comparisons as well as prior years’ “same month” comparisons will inevitably reveal areas in your business where expenses have creeped up and perhaps need better accountability. Examining these expenses regularly in search of trends, both positive and negative, will help you manage your overall costs.

The last item on your income statement is, of course, your net income. The ratio most often used when analyzing net income is the following:
Profit Margin = Net Income / Sales

There is no real mystery to this ratio; it is a measurement everyone understands and reviews regularly. However, this tool is most useful when it is used to compare various periods in your business. Looking at this ratio by itself will give you a measurement of the current month or quarter or year, but evaluating the results in comparison to other periods will help you see trends in your business cycles. For example, don’t just look at the current month’s profit margin; compare it to the same month last year. When you complete a quarter, compare and contrast that full quarter’s profit margins to the prior quarter and the same quarter from the prior year. When you look at a year-end profit margin, compare that to the past several years’ results for a more effective and thorough view of your business.

Finally, consider the so-called “EBITDA” ratio in your regular income statement analysis:
Earnings Before Interest, Taxes, Depreciation, and Amortization

As the name explains, you begin with your net income and add back in interest expense, taxes, depreciation, and amortization expense. This provides you with an accurate measurement of cash flow your business is creating from month to month. Because cash flow is the lifeblood of your business, it’s imperative that you have a tool to provide that information. This is also the primary measurement by which your business is typically valued in the marketplace. Investors and/or buyers in any industry are interested in a company’s cash flow first and foremost, and this is the tool that provides the best analysis of that. An investor or buyer in the marketplace will typically pick a market multiplier for your particular business based on a number of variables and multiply that number by your EBITDA to determine the value of your business. Granted, this is an oversimplification of a business valuation, but your company’s EBITDA is the foundation of that valuation.

Use these ideas to become more thorough in your monthly financial statement analysis. Spend the necessary time to really dig into the numbers each time you review them and you will, as a result, make better business decisions.