Analyzing the Income Statement

March 2005

Here we are on our third e-zine focused on the income statement. In the first of this series, we discussed variable, semi-variable, and fixed costs. In the second, we defined indirect and direct costs as well as gross profit, operating income, and net income. (To catch up on the past few months of e-zines, click here).

In this e-zine, we are going to analyze a simple income statement.

First, let’s look at a simple income statement for Round Number, Inc.

So, Round Number, Inc had $100,000 in sales and ended the year with $10,000 in profit. That is a 10% margin. Pretty sweet.

Pretend that you are whittling a bar of soap

OK, I am showing my Alabama roots here — but I think of the income statement as a huge bar of Ivory soap that we are going to whittle. My granddaddy used to whittle birds and fish out of Ivory soap while sitting on his porch overlooking the lake. Quaint, eh? Too bad business isn’t so cute.

What we want to know is if we have enough soap left to take a shower after we whittle away all of the expenses from total sales.

To make this easier to analyze, I have converted the dollars into percentages:

So in our Round Number, Inc. example, we started off with $100,000 — or 100% of our bar of soap. To pay for direct expenses, or cost of goods sold, we whacked off another 50% of our bar of soap.

Now we have half a bar left. Then we whack off another huge chunk — 3/5 of what remains — so we are left with 20% of our bar of soap. Maybe the size of a small hotel-sized bar.

Next we whack off half of that to pay taxes and other weird expenses to come up with a remaining small ball of soap at 10% of its original size.

How does your organization stack up?

How much of the bar of soap do you have left after whittling away all expenses?

WalMart only has a little over 3% - no that isn’t a typo — 3% — of the bar of soap left when they are done. Virtually a soap flake. But what you have to know about WalMart is that their bar of Ivory Soap is HUGE! But that 3% is 3% of $256 BILLION of total sales or $9 billion dollars. It is not easy to generate $9 billion dollars!

Maybe your business has better margins but not that much in total sales. So, when you end the year, the total dollar amount generated isn’t in the billions of dollars.

In my business, the seminar business, my margins are quite healthy — because the only expense is me and my little training supplies. The reason why my current business model will not allow me to be a millionaire is I can only handle so much volume before passing out! I can only teach so many seminars a year. So, my bar of Ivory soap isn’t that big to begin with — although I get to keep a good chunk of it.

I highly recommend taking your company’s income statement and converting all of the line items into percentages as I have done with Round Number, Inc. All you have to do divide all the other numbers on the income statement by top-line sales.

Trend over time

I also recommend that you trend the data over the years. Analysts and managers do this all of the time to see how well the organization is doing in relationship to prior periods.

Here is an example of a two-year trend analysis:

Look at that bottom line. In both years, we generate a 10% profit by the time we are all through. But there are some mixed results in the second year. Notice that as a proportion of total sales, cost of goods sold has gone up. Is that a good trend? No.

To make up for it, we spent less in operating expenses. Spending less in operating expenses is good, but what did we sacrifice to do it? This, for a manager, is worth investigating. Ideally, we would like to see both cost of goods and operating expenses getting smaller.

Next month, we are going to define more income statement terms. Yes, I know I promised to define EBIT and EBITDA this month in last month’s newsletter… but we weren’t quite ready to learn those yet. Now we are and I’ll do it next time… really I will!