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Our very first consulting client was a home care business. As part of our initial analysis, we asked to see the financial statements, and the owner gave us a three-ring binder with the monthly financial data, i.e. income statement, balance sheet, and cash flow projections.
Related: Income statement
Each three-page statement was neatly stapled in the upper left corner and punched three holes, with no folds by the staple – and no indication that the owner had even looked at the second page.
Immediately, we knew that the client was not using this financial data to help her run her business.
She was not unique. We often find that small business owners do not fully understand how to read their financial statements. That is why we will discuss here how to read these statements. Our six tips will help owners understand what this document (called the income statement, or income statement) is trying to tell you and how to use it to make management decisions.
1. Income statements cover a period of time.
The income statement reveals how much money your business has made over a period of time. Most often, the statement reflects performance over a month, quarter or year. You’ll also see annual income statements that reflect activity from January 1 to the current date (usually the end of a month).
For example, you might see “YTD August”, indicating the period January 1 to August 31. The important point is that income statements always cover a period of time and it is important to note this period.
2. Each income statement follows a simple formula.
Each income statement, no matter how complex, follows a very simple formula: Revenue – Expenses = Profit
It’s that simple. Regardless of the period covered by the income statement, it shows the company’s income, the expenses it has incurred and the profit it has made.
3. Multiple names for an element lead to complexity.
One thing that can make tax returns more complex is that people use different names to refer to the same thing. For example, the term “sales” or “income” can be used instead of “income”. “Expenses” and “costs” are also used interchangeably. “Profit” is sometimes referred to as “net income”.
Don’t let the jargon get you down. Remember, whatever terms you use, the money that comes in minus the money you paid equals the money you keep.
Related: 5 Don’ts of Running a Small Business
4. Expenses are often divided into several parts.
Another thing that can make an income statement seem more complex than it actually is is that expenses are usually broken down into components and profits are calculated at intermediate levels. For example, you will often see:
- Cost of goods sold
- Gross margin
- Selling, general and administrative expenses
COGS are the costs directly related to the products or services you have sold. For example, the material you bought to make the widget you sold and the compensation you paid to the widget builder would be included in the COGS. COGS generally vary directly with revenue, which is a function of the number of widgets sold.
General and administrative costs are those costs which, while necessary, are not directly related to the number of widgets sold. For example, the salary of the president, CFO, and salespeople is typically included in selling and administrative expenses, as are rent and utility bills for the office building. These costs are generally more constant from month to month and do not vary with the number of widgets sold.
5. The gross margin percentage should be relatively constant.
Since the expenses are divided into two parts, profit is calculated at an intermediate level called gross margin. Gross margin is equal to sales less COGS. Gross margin (also known as gross margin) is the money you receive from the products (or services) you sell, minus what it costs you to deliver them. It is very useful to calculate the gross margin as a percentage of turnover:
Percentage of gross margin = gross margin / revenue
The reason this is valuable is that, as explained above, COGS should scale with income. Therefore, the gross margin percentage should be relatively constant. If there is a significant change, say from 40 percent in one period to 20 percent in the next, it should be a red flag. While there may be very valid reasons for such a change, it is important to understand what is going on.
6. Dollars spent on SG&A should be relatively constant.
One more thing to watch out for is the dollars you spend on sales and administration costs. This number should also be reasonably constant from period to period. A significant change in the dollars you spend on selling and administrative expenses should also be a red flag that requires you to dig a little deeper to understand what’s going on in your business.
Related: Avoid These 5 Common Small Business Financing Mistakes
Obviously, there is more to the income statement than we can cover here. However, these tips will come in handy as you glean what your income statement tells you about the health of your business.