Imagine that you’re sitting with a client and he or she has just given you the financial statements of the business and you have to have a short discussion with them about the figures. You don’t have time to analyse the information – that’ll come later – so what should you talk about?
In this post we’ll look at the income statement, highlight the most important figures that you need to look at and suggest some questions that you can ask.
Before you start talking about the figures though there is one thing you must check first…. and that’s the time period covered by the income statement. It’s usually a 12 month period but you shouldn’t just make that assumption – you could be wrong and your understanding of the business’ performance will be way off the mark.
When you look at the income statement there are some general points to keep in mind;
- There will be comparative figures alongside the most recent period. So for each figure you’re going to compare it with the previous year to see whether, and by how much, the figure has increased or decreased.
- That’ll then lead you to ask questions about the changes – in particular, you’ll want to know what caused the changes and how the figures will likely look in the future.
- Whenever you talk about a change in one of the figures, consider whether the cause was an internal issue – for example, the result of a management decision – or an external issue – perhaps a change in input prices from suppliers, the level of competition or a drop-off in consumer demand.
- External issues will be more of a concern because they’re largely outside the control of management and so pose a greater threat to future revenue growth and profitability. For that reason you want to fully understand the future impact of these issues on the business.
So, with that said, let’s get started. Our approach is to work from the bottom of the income statement back up to the top. Our reasoning for that is simple; – we’re more interested in profit than in revenue.
Remember the old saying; Revenue is vanity, profit is sanity.
Following this approach then, the first figure to look at is the net profit for the year which is found right at the bottom of the income statement. Has it increased or decreased?
You might also want to ask about dividends – what is the dividend policy and how much profit is retained in the business to fund future growth? Lenders prefer that most of the profit is retained as it helps to reduce risk when the business grows and needs funding.
The second figure to look at is the operating profit and, as before, the first thing to consider is whether it’s gone up or gone down from the previous year. The change in this profit figure can only be due to one of two things – either gross profit has changed (we’ll come to that in a second) or the operating expenses of the business have increased or decreased.
That brings us to the third figure to look at – the total of operating expenses. As usual, the first question would be – has the total of operating expenses increased or decreased from the previous year?
Look at how the change in the total relates to the change in revenue. If revenue went up we might reasonably expect that operating expenses might also increase even though the two are not directly linked. While there isn’t a direct correlation between a change in revenue and a change in operating expenses, the concern would be if revenue has gone up by a little but the operating expenses have increased by a lot.
The next step then would be to have a look at the individual operating expenses that make up the total to see whether any of them have changed by more than say 10% up or down. If some have changed by more than that, you would want to ask the reasons behind the changes – in particular, you’d want to know whether any increases are necessary for the business’ operations and whether any decreases negatively affect the operations.
The fourth figure to look at is gross profit and this one is especially important for analysts. We are interested in seeing that the gross profit margin should be at least maintained – if not improved on the previous year. The first question, as always, is – has that figure gone up or gone down from the previous year?
There can only be two reasons for a change in gross profit – either revenue has changed or the input costs have changed. The biggest concern would be if the gross profit margin has decreased because of an increase in input costs with no corresponding change in revenue. That implies that these higher costs haven’t been passed on to customers in the form of higher prices.
And the fifth and final figure to look at in this quick overview of the income statement is revenue. This is the top figure on the income statement and reflects the value of product sales made by the business during the period covered by the income statement. Revenue figures always differ from year to year so you would want to know if the difference is caused by changes in the unit price of the product or by a change in the actual number of units sold – or both. Remember that revenue is the result of the unit price of the product multiplied by the volume of units sold.
The final question to ask is – if revenue increased, how does the increase as a percentage compare to the general rate of inflation in the economy. Let’s assume that the inflation rate in the economy is around 6% and the business’ revenue grew by 8%. That means that the real growth in turnover was only the difference; which in this case is 2%. Obviously, as analysts, we want to see a constantly increasing level of revenue in real terms so that measure is important. Just growing revenue at the same rate as inflation is not really adding value to the business.
In the next post, the first five figures to look at in a balance sheet.