Many small business owners aren't certain where to look for key insights. Balance sheet vs income statement? After two articles dedicated to balance sheets - on why and how to use your firm's balance sheet - it's time to turn our attention to the income statement.
Unlike the Balance Sheet, most business owners feel reasonably comfortable in front of their income statement. After all, everyone understands revenue… and who doesn’t watch the bottom line come tax time? But the income statement -- also known as the Profit and Loss Statement, P&L, Earnings Statement or Statement of Financial Performance -- can and should be so much more. Be sure yours provides visibility into each of these 4 areas.
4 INSIGHTS YOUR INCOME STATEMENT BETTER PROVIDE … AND 1 THAT IT WON’T
1. Margins with Meaning
It’s not uncommon for a small business income statement to carry most expenses in the Selling, General & Administrative Expense (SG&A) section, forgoing proper classification of some expenses into Cost of Goods Sold. This classification doesn’t impact a firm’s tax bill since “loose” classification doesn’t change net income. But accurate gross profit (revenue less cost of goods sold) and operating income (gross profit less SG&A) is critical to profitable growth.
A firm’s growth strategy can vary dramatically, depending on its gross margins. What economic value will you receive from increasing revenue by each dollar?What costs and cash are required for growth and how quickly are you paid back for these investments? While the balance sheet is where you look to determine working capital requirements for growth, the income statement quantifies the profit that can be derived from future revenues.
2. Compare, Compare, Compare
An income statement measures revenue and expenses over a period of time (e.g. month, quarter, year). In isolation, it can be informative, but comparing a period with others will cause the insights to jump off the page. If you’re in a seasonal business, how did Q4 compare to the same quarter over the last few years? Or to each of the first 3 quarters of the year… spot a trend? These comparisons highlight changes in cost or revenue which trigger a healthy Q&A which almost invariably influences decision making. Comparisons arm you with questions for employees – why did the travel expenses spike this month? They also show you when you made more (or less) money so you can then ask why.
But don’t stop at comparing time periods, be sure your bookkeeper presents these comparisons:
- Track revenue by product to compare how the individual products are selling.
- Compare the performance of different locations.
- Compare project profitability by client or project size.
The ideal comparisons vary by industry and company stage and size so learn what you should be comparing.
3. Competitive Benchmarking
How is your business performing relative to peers in your market? Is your growth lagging the industry? Is your labor cost heavy compared to the competition? Trade associations aggregate such data and report it to the market. Comparing your results with industry norms helps focus your efforts in areas most likely to yield positive results. And remember from point 1, proper expense classification is critical to accurate comparison. Celebrating a superior gross margin due to “dumping” expenses in SG&A rings hollow. Gauge your progress relative to your competition and your improvement priorities will become clear.
4. Check Your Progress
Yogi Berra is known to have said, “If you don’t know where you are going, you will end up someplace else.” You need a plan. It doesn’t need to be perfect, as future business results can be difficult to project, even a month into the future. But a plan provides direction and allows you to measure traction toward your goals. Compare your income statement to your plan (e.g. monthly projections). It’s critical to understand when you’re exceeding or falling short of your plan when it’s early and while you still have time to ask “why” and adapt accordingly.
Crushing it with Cash Flow. Now for that insight people often expect, but won’t find in their income statement. Everyone has heard that “cash is king.” Well, it is. It’s your firm’s ability to generate cash when you need it that drives your ability to invest in growth, make that next hire or simply make payroll. But don’t study the income statement, in isolation, to understand your cash position. To fully understand your firm’s cash position, look to your statement of cash flows (a topic for a future post) and your balance sheet.
Too many owners breathe a sigh of relief and move onto other issues when they see a positive net income, taking it as a proxy for cash flow. Your income statement presents the money earned in a specific period. However, the timing between earning revenue and getting paid often varies. So does the timing between incurring an expense and cutting a check. Therefore, the actual cash inflows and outflows often deviate from net income. For example, if sales drop in January, the cash balance might be OK for the next 45 days while the accounts receivable balance shrinks but without new sales in a hurry your cash position will be strained all too soon. The income statement presents only part of the picture so use it in conjunction with the other key financial statements.
Profitable growth doesn’t just happen. It’s achieved through a thoughtful, deliberate process, starting with sound bookkeeping. An income statement can be a powerful tool along the way. Take action to ensure yours provides the data you need to make sound decisions.
THE DRIVEN INSIGHTS ADVANTAGE
Driven Insights is experienced in leading service businesses on the journey to leveraging financial and operating metrics to accelerate growth. Our bookkeepers and controllers are charged with much more than simply “doing the books” – they ensure each client understands and uses the insights we share.
Interested in learning more? See for yourself how Driven Insights can provide the insight and control you need to achieve your most critical goals by contacting us at firstname.lastname@example.org or 888-631-1124.