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When reviewing their income statements, business owners tend to focus on profits (or losses). But focusing solely on the bottom line can lead to mismanagement and missed opportunities. Instead, you should analyze this financial report from top to bottom for deeper insights.<\/p>\n
Think like an auditor <\/strong><\/p>\n Review your company\u2019s income statement with an auditor\u2019s mindset. External auditors are trained to have professional skepticism, ask questions continually and evaluate evidence without bias. They pay close attention to details and rely on data to identify risks and formulate evidence-based conclusions.<\/p>\n This approach can improve your knowledge of your company\u2019s financial health and help you make more strategic decisions based on the key drivers of profitability \u2014 revenue and expenses. It can also help expose fraud and waste before they spiral out of control.<\/p>\n Start with revenue<\/strong><\/p>\n Revenue (or sales) is the money generated from selling goods or services before any expenses are deducted. It\u2019s the top line of your income statement.<\/p>\n Compare revenue for the current accounting period to the previous period and your budget. Has revenue grown, declined or held steady? Did your company meet the sales goals you set at the beginning of the year? If not, investigate what happened. Perhaps management\u2019s goals were unrealistic. Alternatively, the cause might relate to internal issues (such as the loss of a key salesperson or production delays) or external issues (such as the emergence of a new competitor or weak customer demand). Pinpointing the reasons behind lackluster sales is critical. View internal mistakes as opportunities to learn and improve performance in the future.<\/p>\n Evaluating revenue can be particularly challenging for cyclical or seasonal businesses. These businesses should compare results for one time period to those from the same period the previous year. Or they may need to look back more than just one year to evaluate revenue trends over an entire business cycle.<\/p>\n It also may be helpful to look at industry trends to gauge your business\u2019s performance. If your industry is growing but your company is faltering, the cause is likely internal.<\/p>\n If your business offers more than one type of product or service, break down the composition of revenue to see what\u2019s selling \u2014 and what\u2019s not. Variances in sales composition over time may reveal changes in customer demand. This analysis can lead to modifications in marketing, sales, production and purchasing strategies.<\/p>\n Move on to cost of sales<\/strong><\/p>\n The next line item on your company\u2019s income statement is the cost of sales (or cost of goods sold). It includes direct labor, direct materials and overhead. These are costs incurred to make products and provide services. The difference between revenue and cost of sales is your gross profit.<\/p>\n Look at how the components of cost of sales have changed as a percentage of revenue over time. The relationship between revenue and direct costs generally should be stable. Changes may relate to the cost of inputs or your company\u2019s operations. For example, hourly wages might have increased over time due to inflation or regulatory changes. You might decide to counter increasing labor costs by purchasing automation equipment that makes your company less reliant on human capital or adding a shift to reduce overtime wages.<\/p>\n Changes in your revenue base can also affect cost of sales. For instance, if your company is doing more custom work than before, the components of direct costs as a percentage of revenue will likely differ from past results. Evaluating gross profit on a product or job basis can help you understand what\u2019s most profitable so you can pivot to sell more high-margin items.<\/p>\n It\u2019s also helpful to compare the components of your company\u2019s cost of sales against industry benchmarks. This can help evaluate whether you\u2019re operating as efficiently as possible. For instance, compute your company\u2019s direct materials as a percentage of total revenue. If your ratio is significantly higher than the industry average, you might need to negotiate lower prices with suppliers or take steps to minimize waste and rework.<\/p>\n Monitor operating expenses<\/strong><\/p>\n Operating expenses are ongoing costs related to running your business\u2019s day-to-day operations. They\u2019re necessary for a company to generate revenue but aren\u2019t directly tied to producing goods or services. Examples of operating expenses include:<\/p>\n Many operating expenses are fixed over the short run. That is, they aren\u2019t affected by changes in revenue. For instance, rent and the marketing director\u2019s salary usually don\u2019t vary based on revenue. Compare the total amount spent on fixed costs in the current accounting period to the amount spent in the previous period. Auditors review individual operating expenses line by line and inquire about any change that\u2019s, say, greater than $10,000 or 10% of the cost from the prior period. This approach can help you ask targeted questions to find the root causes of significant cost increases and make improvements.<\/p>\n To illustrate, let\u2019s say your company\u2019s maintenance costs increased by 20% this year. After further investigation, you might discover that you incurred significant, nonrecurring charges to clean up and repair damages from a major storm \u2014 or maybe you discover that your payables clerk is colluding with a friend who works at the landscaping company to bilk your company for excessive fees. You won\u2019t know the reason for a cost increase without digging into the details like an auditor would.<\/p>\n Use the income statement as a management tool<\/strong><\/p>\n Your company\u2019s income statement contains valuable information if you take the time to review it thoroughly. Adopting an auditor\u2019s mindset can help business owners identify trends quickly, detect problems and anomalies early, and make better-informed decisions. Contact us for help interpreting your company\u2019s historical results and using them to improve its future performance.<\/p>\n \u00a9 2024<\/em><\/p>\n <\/body> When reviewing their income statements, business owners tend to focus on profits (or losses). But focusing solely on the bottom line can lead to mismanagement and missed opportunities. Instead, you should analyze this financial report from top to bottom for deeper insights. Think like an auditor Review your company\u2019s income statement with an auditor\u2019s mindset. 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