The income statement, also called profit and loss statement, gives you the details of where your money came from and where you spent it on. It takes a close review of the figures to really know how your business did over a certain period. While the income statement reports on what happened in the past, it can give you a very good idea of what to expect in the future if you continue at the rate you are going. If you like what you see, you can safely carry on the same activities. If not, then you have the information needed to take corrective action.
Take for example your gross profit margin (gross profit/sales). This can clue you in on how effective your pricing policies are although you will need to compare your gross margin against the industry average. For all you know, you might be pricing out yourself against competition, or you have priced your products too low you are missing out on your profit potentials.
Make sure to examine all your expenses in relation to your sales. You will need to see your expense item as a percentage of sales to determine how wisely you have spent to generate sales. This way, you can adequately compare your performance to your competitors without regard for the dollar values. Let’s assume you have spent $5,000 on advertising while your sales amounted to $50,000. That is an advertising-to-sales percentage of 10%. Then again, if your competitor paid $8,000 but made $125,000 in sales, his 6.4% advertising-to-sales ratio shows that his approach was more effective than yours. In this case, you may want to rework your own promotions program.
You can better interpret your income statement if you analyze it in tandem with your balance sheet. You will need to combine information from the two statements to compute the relevant ratios and compare yours with industry averages.
The inventory turnover ratio (cost of goods sold/inventory), for instance, will tell you how many times you have converted your inventory into sales. It is indicative of your efficiency in purchasing and production. Poor sales performance is usually exhibited as a low turnover rate that is why there is excess inventory while a high ratio can point to either brisk sales or inefficient buying.
The next item to check is your sales-to-receivables ratio (net sales/receivables) or the number of times you have turned over your accounts receivables. Again, a higher ratio figure is preferred as it indicates the efficiency of your collection system. A related ratio is the days’ receivables ratio (365/sales receivables ratio) that shows the average time that lapse between the sale transaction and actual receipt of the cash.
By measuring your return on assets (net income before taxes/total assets), you will know how efficient you have been in using your assets to earn your profits. Getting a ratio lower than your competitors should be a signal for you to start streamlining your own operations.
You must already be familiar with the term return on owner’s equity (net income/owner’s equity). If you had more than one option to invest your money, this figure should validate if you made the right decision to start your business. Of course, you cannot expect a high profitability rate during the initial year.
Even if your profitability falls short of your expectations, at least you know now where to make changes and you also have the means to measure your progress.
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