Income Statement: Examples and Analysis
As we’ve discussed in the previous lessons, knowing how to read an income statement is a critical skill to have, no matter how big or small your ecommerce business is. Not only does it help you assess your company’s financial progress, it helps you predict and plan accordingly for future opportunities.
Who analyses the income statement?
Everyone from business leaders, owners, analysts to investors use the income statement to gain a full picture of the company’s operational outcome. A good analysis of your income statement can reveal a great deal about your business.
How does an income statement analysis help?
You can find answers to questions such as whether or not your sales are improving and if the total expenses are taking a toll on your ability to generate more revenue. It also helps you decide where and when you need to cut spending and redirect resources
In this lesson we’ll be covering two of the most important methods of income statement analysis with examples, which will enable you to gain insights about your business and make well-informed decisions.
Types of Analysis
There are two common methods used to analyse any company’s income statements: Vertical analysis and Horizontal analysis. First let’s walk you through the vertical analysis approach.
This is a method of analysis where you go through the income statement, top to bottom and see how every line item has turned out, compared to the revenue. The figures will be stated as a percentage of the revenue (ie;sales).
In other words, each line item is stated as a percentage of the base figure given in the income statement and not in terms of the exact amount of money.
It can be described as a process of analysing the relationship between each line item and how it contributes to the revenue and retained earnings in terms of percentage, share and size.
Common size income statement
Presenting all the line items in an income statement as percentages of revenue (net sales) is also referred to as a common-size income statement. It is a technique that’s commonly adopted in financial statement analysis by managers and analysts to better visualise the relative proportion of each item and its effect on the business performance.
Furthermore, it helps you determine how each account affects the company’s overall profitability in terms of their relationship to each other. This also gives investors a clear picture of the proportion of expense to revenue and how they help generate net income.
A common size income statement is generally how horizontal analysis is done in most companies when they evaluate the business performance over multiple time periods.
Why is it popular?
Vertical analysis is easily applicable for financial statements across different time periods (months and years), companies and even industries. This is because instead of focusing on the actual amount, we’d be focusing on the relative proportions, which is much more relevant. This way you can easily spot which metrics are showing improvement and which ones are falling short.
Horizontal analysis compares the changes in each line item across different periods (year-over-year or month-over-month). This is unlike vertical analysis where each line item is given as a percentage of the base figure (revenue) during the current period. It is used in comparing monetary amounts as well as percentages however, the analysis takes place over multiple reporting periods which is the key difference.
It is generally the go-to method of analysis that helps you spot patterns and ask the right questions such as: Which line items are helping the profits margins grow? Why did the cost rise or fall?
Simply put, horizontal analysis offers an emphasis on consistency. It makes sure that the company’s growth or decline can be tracked over lengthy periods, compared to competitors.
This is why horizontal analysis is commonly favored by investors and analysts, because it offers a picture of the company’s growth patterns and trends, which are easy to spot when you consider the change in figures across multiple years.
Should you use both?
Leveraging both vertical and horizontal analysis can offer you a much more in-depth and accurate view of your business, which provides you all the information you need to make an educated decision. If your business has been running for several years, then combining horizontal as well as vertical analysis when you read your income statement is a great way to go about it.
Examples of Both Methods:
The following is a monthly income statement of a fictional company. Let’s call it ABC:
|Income statement of ABC for the month June-July 2020|
|Cost of Goods Sold||$20000|
|Salaries and General & Administrative Expenses||$12,000|
|Earnings before Tax||$12,000|
Now let’s show you how this statement would be when we do a vertical analysis. Remember, all the listed items will be represented as a percentage of the revenue.
|Income statement of ABC for the month June-July 2020|
|Cost of Goods Sold||$20000||40%|
|Salaries and General & Administrative Expenses||$12,000||24%|
|Earnings before Tax||$12,000||24%|
Notice how in this example, we took every key metric as a percentage of the revenue, which is $50,000 for the month. For eg:the cost of goods, which is $20,000 makes up 40% of the revenue, which we deducted. The same applies for all the expenses and the remaining profit as well. At the end, we can surmise that the business has been able to make a profit of 20% during the month.
Let’s take the previously given example along with statements from a few other months to do a horizontal analysis.We will be tracking the revenue growth (or decline) across this time period.
Income statements for the months June, July and August are given. Note that June is taken as a base month.
|Cost of Goods Sold||$20000||$22000||$24000|
|Salaries and General & Administrative Expenses||$12,000||$12,000||$12,000|
|Earnings before Tax||$12,000||$13,000||$14,000|
Now this is how a horizontal analysis of the above income statement would look like:
|Cost of Goods Sold||na||10%||9%|
|Salaries and General & Administrative Expenses||na||0%||0%|
|Earnings before Tax||na||8%||8%|
Some inferences you can make from the horizontal analysis depicted above:
- Notice that June has been taken as a base month. All the line items of July are represented in relation to the values for June. Likewise all the percentages assigned to line items in August are based on the previous month, ie; July.
- The 1% drop in the revenue rate for August compared to July is not a fall in the amount of profit that the company is making. Rather, it represents a slight decline in the rate of growth compared to revenue figures in July. However, this is a mute point when you also consider the expenses that have been cut short.
- The business has been able to cut down on its utilities spending significantly. The strategies that allowed such a positive change must be looked into even further.
This is just an example of the conclusions that can be drawn by analyzing your business’ income statement using the horizontal method.
Tips for analysis:
Reviewing an income statement can be a hassle for beginners. If you’re experiencing some apprehension over where to start, don’t worry. Here are some tips to help:
Make sure the math adds up
Errors are quite common, even in published financial statements. At the end of the day, you’re going to be dealing with a lot of numbers so it’s important that you make sure that all the calculations are sound.
Focus on the bottom line
At a very basic level, every company strives to maintain a positive number at the bottom line. This means earnings exceed expenses, which means the business can pay its employees and sustain itself.
However, if for some reason your bottom line is a negative figure, then you might have your work cut out for you. You’ll have to find out why and how the expenses surpassed revenue. Once you do you’ll have to decide on a strategy to change that.
Should net losses be a cause for alarm?
Note that a net loss once in a while is not a big deal and doesn’t always mean disaster. Start-up costs can sometimes keep your company from turning a profit in the initial stages. However, if your business is facing consecutive net losses, then you’ll have trouble paying off your expenses which is a problem. So always try to keep net losses from becoming a trend.
Look for sustainable sources of income
The income statement helps you differentiate between stable sources of income that you can rely on as well as random income. For eg: you’ll be able to discern between revenue you made on cashback offers that you acquired through using a special payment portal or platform and the actual sales revenue.
In other words, you’re able to find out which of your sales were tied to special events and occasions that you got to cash in on and which of them are regular reliable sources. When it comes to sustainability, you will be looking for repeated sources of income.
Check your expenses
Make sure that all the listed expenses are logical. The most common expenses you find for any business is rent, supplies, utilities etc. Check and see if there are missing figures or accounts that don’t add up. The income statement is where you can easily spot redundant payables.
Look for huge expenses.
Let’s say you run a service business. Naturally, you’d see a large number for salaries. However, if you’re a minimally staffed company and your salary margins display a significant amount, you might have to look into it and find out if someone is being overpaid and whether it is worth it.
Compare numbers over the years.
When you’re conducting horizontal analysis, focus on the rates of growth and decline. Look for common trends and patterns. It is not the amount you should be concerned with as much as the percentages. These will reflect the real changes that have occurred in your business.
Knowing how to effectively analyse your income statement is an essential skill that you must have. It helps you gain a good idea about your business and what direction it is heading in.
Vertical analysis can help you assess the relationship between multiple variables in your business and how they contribute to the outcome, which is more suitable when you’re looking for ways to maximise your revenue.
In addition to this, horizontal analysis is a method that helps you track your growth and progress over a period of time by taking a much more wider view. It also helps you identify what’s working and enables you to spot trends and patterns that can inform your strategy.
Both methods can be combined to give you valuable in-depth insights about your business so that you can make winning decisions that are grounded in objective analysis.