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.

When reading an Income Statement start at the top, see a summarized Income Statement below. Gross Revenue is the first line item on the Income Statement. Gross Revenue is the accumulation of your sales. You can review your Income Statement monthly (required), weekly or even daily (depending on the accuracy of daily recording keeping).

If you own a business that sells products, i.e., you have inventory, you should have the line item Cost of Goods Sold. Cost of Goods Sold is the expense associated with the products you sold. You would have purchased these inventory items to sell in your wholesale/retail or online stores. Once these inventory items are sold you convert the asset into an expense, i.e., Cost of Goods Sold. If you have a service business you may report direct costs in the Cost of Sales account.

The Gross Profit is determine by subtracting the Cost of Goods Sold (or Cost of Sales) from the Gross Revenues. The Gross Profit is the amount of “money” you have left over to pay for operating expenses such as rent, utilities, staff salaries, insurance, phone, etc.

After you calculate the Gross Profit, you need to subtract the Operating Expenses. Operating expenses are the indirect cost incurred to run the business, such as rent, utilities, phone, and marketing expenses.

The last line on the Income statement will be the Net Profit. Hopefully this line item is a positive number. The Net Profit tells you how much “profit” you have per every dollar in Gross Sales. This is not necessarily your cash profit, especially if you had depreciation or made large purchases of equipment during the period.

Summarized Income Statement

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Gross profit is found by taking the net sales minus the cost of goods sold. For example, to find gross profit, a dressmaker make add up all of the receipts for the dresses sold, then subtract the cost of the fabric, thread, thimbles, the wages paid to a junior dressmaker who helped sew the dresses. The result is the amount of profit made only considering direct costs, i.e., gross profit. To convert the dollar amount into a percentage, take the gross profit divided by net sales, and multiplying by 100. While you can compare your result to other companies in your industry, it is generally difficult to accurately compare across companies using this calculation, so this is often done as an internal measure to see how the business is doing from year to year. Compare this ratio to the same month of the prior year or the previous month to spot any significant trends.

Net profit are the earnings remaining after you have accounted for all expenses, including depreciation and taxes. Net profit margin is found by taking the net profits (which is the profit after taxes have been paid) divided by revenue, multiplied by 100. Net profit can be used to compare your results to other companies within your industry. Since all items have been accounted in calculating the net profit margin, it allows for more comparability to the industry standard or your competitors.

Ratios provide a great means for measuring and monitoring business performance. These are just two of the many ratios that might be applicable to your business.

While cash is King, the balance in you checking account doesn’t tell you what you are doing right or wrong in your daily operations. The Income Statement (aka Profit and Loss Statement) does. Sometimes Net Income is mistaken for cash flow. While the two items are related, they are not the same, especially if you use the accrual method of accounting or have depreciation and/or amortization expenses.

Net Income is the profit generated by your daily operations. This figured includes all of your sales (aka revenues) and expenses (such as rent, utilities, auto, meals, travel, depreciation, interest, etc.). Some of the expenses used to calculate Net Income are considered “non-cash” items, such as depreciation and amortization. However, depreciation and amortization do not impact cash flow.

If you use the cash basis method of accounting usually the only difference between your Net Income and Cash Flow will be the non-cash items. However, if you use the accrual method of accounting the difference between Net Income and Cash Flow will be a little more complicated to calculate because you have to take into consideration the changes in your Accounts Receivable, Inventory, Accounts Payable and many other accounts.

There is no general rule that says Net Income is always higher than Cash Flows or vice versa. It is a good idea to ask your bookkeeper to prepare both the Income Statement and Statement of Cash Flows each month so that you can track the trends of your operations and how those items impact how much cash you have in the bank.

I just finished helping two business owners prepare projections for their business ventures. The problem with an estimated projection of the future is that it is rarely 100 percent accurate. Generally you will not earn as much in revenues as you anticipate and your expenses will be higher. The expenses will be higher in part because items were left out, either intentionally or unintentionally.

Creating a pro forma is not a waste of time because it forces the business owner to really think about what the business can achieve. Can you really sell 100,000 widgets with only 1 sales person, i.e., yourself? When you put numbers on paper you have take an honest look at what needs to happen from a financial perspective to create and sell your products or services.

The real challenges for business owners is not the time it requires to create a pro forma/projection, but creating one that is realistically achievable. Does it really do you any good to underestimate your expenses or overstate your revenues? Do you think the bank or investor won’t doubt your numbers? They will, even if your numbers are totally realistic.

The problem with pro forma financial statements isn’t that they are unrealistic or unachievable, it is that often times the data used to create them isn’t accurate or there are too many unknowns. Yearly projections are a good business practice. These exercises can help you and your business be more profitable as long as the information used to create them is considered high-quality and items are not left off in order to make the numbers “look” good.

Unlike the purchase of supplies the purchase of a large asset, such as a car, is “capitalized”. What this means is that you don’t recognize the full cost of the car as an immediate expense. Instead, you report the value of the car on the Balance Sheet as an asset. You should have a corresponding debt for the car in the liabilities section of the Balance Sheet, unless you paid cash for it. Then you determine the life of the asset, cars are generally considered to have a useful life of 5 years for depreciation purposes. As such, the cost of the car would be allocated to the income statement for each of the next 5 years. We’ll ignore the Balance Sheet aspects for now.

Depreciation is what we commonly refer to as a “non-cash” expense. Continuing with the car example, if we pay for the car with cash our cash outflow is in the first year, yet we allocate the cost of the car over 5 years. Which means that the profitability of your company is going to be impacted by the depreciation even if you no longer have any car payments because the payment of the asset and the allocation of depreciation expense do not take place simultaneously.

Depreciation allows you to better match the useful life of the asset with the revenue you are generating due to the benefits produced by that asset. If you were to expense the entire value of the asset in the year of purchase your profits in that year would be unnecessarily low and future years too high.

There are many ways to measure the profitability of your company. Income taxes are calculated based on net income, including all non-cash expenses. Whereas you can also look at cash basis profitability which would only include items that actually increase or reduce cash. Sometimes business owners like to see a line item on their income statement that is commonly called EBITDA (earnings before interest, taxes, depreciation and amortization). Another approach that I use for my clients is EBDA (earnings before depreciation and amortization) so that they can compare their net profits with non-cash expenses included to their net profits based mainly on cash only items. Figure out what works for you and use that as a measure to determine your monthly, quarterly and yearly goals.