By midyear, most businesses that follow U.S. Generally Accepted Accounting Principles (GAAP) have issued their year-end financial statements. But how many have actually used them to improve their business operations in the future? Producing financial statements is more than a matter of compliance — owners and managers can use them to analyze performance and find ways to remedy inefficiencies and anomalies. How? Let’s start by looking at the income statement.
Ratio analysis facilitates comparisons over time and against industry norms. Here are four ratios you can compute from income statement data:
1. Gross profit. This is profit after cost of goods sold divided by sales. This critical ratio indicates whether the company can operate profitably. It’s a good ratio to compare to industry statistics because it tends to be calculated on a consistent basis.
2. Net profit margin. This is calculated by dividing net income by sales and is the ultimate scorecard for management. If the margin is rising, the company must be doing something right. Often, this ratio is computed on a pretax basis to accommodate for differences in tax rates between pass-through entities and C corporations.
3. Return on assets. This is calculated by dividing net income by the company’s total assets. The return shows how efficiently management is using its assets.
4. Return on equity. This is calculated by dividing net profits by shareholders’ equity. The resulting figure tells how well the shareholders’ investment is performing compared to competing investment vehicles.
For all four profitability ratios, look at two key elements: changes between accounting periods and differences from industry averages.
Plugging profit drains
What if your company’s profitability ratios have deteriorated compared to last year or industry norms? Rather than overreacting to a decline, it’s important to find the cause. If the whole industry is suffering, the decline is likely part of a macroeconomic trend.
If the industry is healthy, yet a company’s margins are falling, management may need to take corrective measures, such as:
- Reining in costs,
- Investing in technology, and/or
- Looking for signs of fraud.
For example, if an employee is colluding with a supplier in a kickback scam, direct materials costs may skyrocket, causing the company’s gross profit to fall.
For clues into what’s happening, study the main components of the income statement: gross sales, cost of sales, and selling and administrative costs. Determine if line items have fallen due to company-specific or industrywide trends by comparing them to public companies in the same industry. Also, monitor trade publications, trade associations and the Internet for information. Contact us to discuss possible causes and brainstorm ways to fix any problems.