Well, friends, welcome back for part two of our series on how to analyze your financial statements. You know, those boring things that the accounting department produces once a month for you to review and give you a reason to pull your hair out. You may think this is a sarcastic remark, but there really are certain parts of most organizations that think the overall financial statements are useless. Useless, that is, until it comes time to calculate bonuses and they swear the accountant charged costs to their department unfairly!
Well, we are the accountants who charge the costs unfairly and we take exception to such accusations. You, as the owner or manager, should also take exception when someone reviews your financial statements and challenges their validity. That’s why we've taken the time to write down a few key concepts you should consider about the income statement in this article.
The first thing to bear in mind for the analysis of a financial statement is “Numbers don’t lie, but people do.” So look carefully at what you are given and be certain it makes sense. For example, assume you're the sales vice-president and you know that you sold 5,000 units of Baby-Soft Diapers last month. When the monthly management meeting comes around and Fred Frugal, the accountant, hands out the financial statements, and everyone sees the sales for the month is only $15,000, they all go ballistic from the president on down. You calm him down by telling him it’s obviously a mistake because it doesn’t make sense that you have only $15,000 in sales when you sold 5,000 units at $10 per unit. Woe be it to you if you don’t take the time to analyze the financials with a skeptical eye and a mistake like this goes unnoticed!
The second rule is “Don’t analyze ‘til your brain fries." Some people really like numbers and really like to calculate every little thing. Let us illustrate. Suppose you have a company that has $10 million in sales and $1 million in net income. Suppose also that you're looking at expenses as a percentage of budget and you notice the technical services department spent twice the budget in entertainment. Should you go ballistic and demand a full accounting? Well, let's take a closer look.
What if I told you the budget for technical services was only $100 and they spent $200. Do you really care? Some people do but we would suggest that for such small amounts, to demand justification is counterproductive. You'll spend far more in time tracking down one small item than you'll gain from having the information.
Set a dollar threshold of what's important to you in managing your business. Then stick to it. You just about have to or you'll spend too many dollars chasing after those proverbial dimes.
The Types of Analysis
There are several ways to analyze your financial statements. A commonly used method relies on raw numbers. Year-to-year, month-to-month and quarter-to-quarter comparisons of income statement items using actual data are examples of using raw numbers. Another way would be the same type of comparison, but comparing actual results to budgeted amounts.
Ratio analysis can also be used. You can compare certain significant ratios from period-to-period just as you can the raw numbers. Ratios may be even more important in an industry that publishes operating statistics since this allows you to compare your company to another.
A Picture is Worth 1,000 Words
A working example might be helpful here so let's look at Beautiful Baby Diaper Company. What follows are the Beautiful Baby Diaper Company’s annual income statement and budget for 2001. For simplicity the budget amounts are based on the prior year plus a 10% increase in costs and 25% increase in sales and cost of sales.
|Cost of sales||500,000||625,000||(125,000)|
|General & administrative expenses||220,000||220,000||-|
|Total expenses ||420,000||440,000||(20,000)|
|Liabilities - all accounts payable||$150,000||$100,000|
|Total liabilities and equity||$300,000 ||$220,000|
One of the methods most often used by managers to judge their performance is to compare current results against budgeted results. Assuming the budgets were properly prepared, the measurement of actual results against expected results can be an invaluable tool. Let’s take a look at our example and see what we can learn.
The most significant aspect of our balance sheet is that sales did not meet the target, but the question is why? Did the sales manager do a lousy job or was the market as soft as a baby’s you know what?
Perhaps answers can be found in the expense section. Take a look at sales expense. As it turns out, the answer is a combination of possibilities. The market started slower than expected, so management pulled back on the advertising budget believing it would be a waste of marketing money. Unfortunately, the market turned around in the second quarter and the company’s competitors who kept their name before the public got the $250,000 in sales that Beautiful Baby Diaper Company did not get.
Meanwhile, the company geared up for the expected additional sales and added to its plant and certain general and administrative costs. These costs met the budget, but the sales level ultimately didn’t justify the expenditures.
Bottom line? Last year, Beautiful made $100,000 in pre-tax income. This year, due to some miscalculation, income was down on the same amount of sales. Not only that, inventory levels are high, debt has increased and the creditors are not happy campers.
Let’s turn to some ratio analysis. There are numerous ratios, but we'll stick with the more widely used ratios.
- Gross margin is the percentage of profit built into sales. In our example, gross margin remains constant at 50% ([Sales-Cost of sales] divided by Sales). This suggests we're managing our production process as efficiently as the prior year. If industry norms are in the 50% range, then that aspect of our operations is good. The V.P. of production gets a gold star. If industry norms are really 60%, perhaps the V.P. of operations should only get a bronze star.
Pre-tax and after-tax income to sales
– These ratios are what they sound like. Take pre-tax profit, divide it by sales and you get a measure of how well you employed all of your capital and not just your production capacity. Comparison of this profitability ratio against industry norms can be extremely valuable in determining whether or not you have a problem. Now, the after-tax income to sales comparison provides helps you to quickly determine if you're making the best possible use of tax planning. Of course, you may have no options if you live in a high tax state, but at least you'll have a basis to compare your overall profitability to other companies.
The average profit before tax for the Diaper industry in 2001 was a little over 12%. Compared to the industry, Beautiful’s 8% does not look great.
Expenses as a percentage of sales
– When you compare specific expenses, or categories of expenses, as a percentage of sales to prior years and industry norms can be useful in flush out misstatements in expenses or if there are impending problems. In the case of Beautiful Baby Diaper Company, the costs did not compare favorably to industry norms. The average advertising and sales expense of Beautiful was 20% compared to 18% for the industry. Beautiful’s general and administrative expenses were 22% of sales compared to 20% for the industry. This suggests Beautiful needs to look at its cost controls.
Profit isn’t everything
Let's turn back to the balance sheet for a moment. There are several items that shed light on Beautiful’s current operations. For example, one of the ratios many investors and bankers use is the net income to net worth ratio. Unfortunately, Beautiful did not fare well here. Their net income of $80,000 as a percentage of net worth was only 53.3%.
Only 53.3%, you say! Most people would kill for that ratio. True, but last year, the ratio was 83.3% and this is a cash generating industry. Generally, Beautiful has been able to throw off dividends of $75,000 to $100,000 to the shareholders, but not this year. The industry norm is 75% and climbing while Beautiful’s is 53.3% and falling.
Profit is important, but equally as important is the direction the profit takes. Profits that show consistent increases allow management to declare more dividends, assuming capital outlays aren’t required. This in turn makes the company more valuable.
If you remember last month’s discussion, you'll notice right away that the quick ratio, the current ratio and every other key ratio in Beautiful's statement have plunged in 2001. So, we have a significant negative effect on the financial position of Beautiful Baby Diaper Company due to this year’s operations. Income was down and so were dividends ($50,000 in 2001 versus $80,000 in 2000). The financial position of the company has deteriorated and all because of one major income statement item – sales expense. Management quickly keyed in on the source of the problem by taking the time to critically evaluate the income statement.
So what did management do the following year? If you guessed they increased their marketing budget, you are correct. In fact, over the next few years, they plan to continue to invest heavily in marketing and they will eventually find themselves among the top three diaper makers in the world. And all this from a simple income statement analysis. Imagine that.
Ok, we admit Beautiful’s income statement analysis may not necessarily reflect everyone’s experience. However, we've been down this road with enough of our clients and seen the benefits they've reaped to know how valuable an exercise it is. If you aren’t using your financial statements to their fullest extent possible, don’t you owe it to yourself to learn how? Give us a call. We will be glad to sit down with you and discuss how you, your financial statements and our expertise can enhance the return from your business.
Have a great February!