The Income Statement: How to Use it
Once you have the Income Statement prepared, see The Income Statement: How to Read it post, it is time to compare your results from the current month to the prior month. Using the same logic, compare your current results to the same month of the prior year. In what areas did your business improve? What areas didn’t do as well?
First compare the prior month and same month the prior year by looking at the gross dollar amounts. You can gain some basic information about how your business is doing. While the dollar figures provide some information as to what areas to focus on in the future, it is helpful to convert some of this information into percentages to get a more accurate picture. For example, let’s assume that your Gross Revenues decreased slightly from May to June. It should follow that your Cost of Goods Sold decrease too. Assume that in May the Gross Margin was 60% but in June it was only 55%. What happened? Did your vendors increase their costs? Or did you sell your products at a discount in order to generate more sales? What is the trend in the Gross Margin over 6 months? Over 3 years?
There are many other ratios you can use to evaluate your business using the Income Statement. Since every business is different there is not one ratio that is necessarily more important than the others. Two of my favorites are:
1. Receivables Turnover (Net Credit Sales/Average Net Receivables) – provides the number of times per year that you are collecting your outstanding Accounts Receivables. You can convert this into days using the following formula: (365/Receivables Turnover ratio)=days.*
2. Profit Margin ratio (Net Income/Net Sales) – provides the rate of the conversion of sales into profits.
It is important to monitor the balance of cash in your checking account. However, a review and ratio analysis of the Income Statement will help determine how effective you and your business have been generating and using cash.
*Note, the Receivables Turnover ratio includes an item, average Net Receivables, from the Balance Sheet.
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July 8th, 2010 at 9:17 am
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July 19th, 2010 at 11:18 am
I review our Income Statement and P & L statement every month or so. I find it really helps me to see where spending could be streamlined. I’m glad I developed this habit. I think the financials make business owners afraid sometimes. I know they did for me, until I just made it a regular habit to look at them for what they are and detached myself emotionally from them. Great info, Kelly.