How to Analyze an Income Statement
Financial Analysis to many Small Business owners comes across as rocket science or overly complex. Well, that doesn’t have to be the case.
In this post, you are going to learn some basic, yet powerful financial analysis. Today you are going to learn how to analyze an Income Statement and I promise you it will not be as difficult as you may think.
Let’s start by defining what financial analysis is. Financial analysis is simply taking a financial report and performing a few basic calculations to gain more insight into the financial performance of a business. Learning how to analyze an Income Statement is a great starting point as you learn how analytics can be beneficial to your small business.
Basic Income Statement Financial Analysis
By analyzing the Income Statement, you can dig deeper into the performance of a small business. The following are a few basic measures to get you started.
By taking the current period Revenue and comparing it to a prior period you can determine the Revenue growth of the small business. Calculating this on multiple periods will evaluate a revenue growth trend. This trend will indicate if revenue is growing or contracting over time.
The revenue growth calculation is as follows:
Revenue Growth = (Current Period Revenue/Prior Period Revenue) – 1
($125,000/$100,000) – 1 = 25%
In this example, we see that the revenue for this company has grown by 25% from the prior period measured.
Analyze Expense Growth:
By taking specific expense line items, you can calculate their growth or contraction over time as well. If we take your rent expense as an example, how much has it increased as a percent over the last five years? How does this compare to the market average for your area?
This can be an eye-opening metric when you calculate it for the first time. It may expose that your rent expense is well above the area average and a discussion with your landlord should happen sooner than later. This simple period over period measurement could potentially save you and your business a lot of money.
Expense Growth = (Current Period Expenses/Prior Period Expenses) – 1
($15,000/$13,000) – 1 = 15%
Analyze Line Items as a % of Revenue (Common sizing):
Viewing each expense line item as a percent of revenue is a simple way to normalize expenses for comparison purposes. This practice is known as Common-sizing a financial statement and allows for easier comparison of business that varies in size.
In other words, comparing your small business which does $1MM in annual revenue to a public company in the same industry which does $1B in yearly income is laughable to some extent. By common sizing financial statements, this comparison becomes a lot less ridiculous.
For example, the $1B business may have rent expense that is 2.5% of revenue while your company may have rent expense that is 2% of revenue. So in effect, your business compared to the public company has a rent expense that is in line with the norm.
These percentages can be used to compare your small business to industry benchmarks or even competitors.
Expense % Revenue = Expense/Revenue
(Salaries/Revenue) = Salaries as a % of Revenue
Analyze Margin Growth:
Margins indicate the profitability of the small business. By dividing each margin including, Gross Margin, Operating Margin and Net Income by Revenue you can determine the profitability as a % of Revenue.
By comparing your margins to your competitors (if the data is available) or industry average, you can gain viable insight into the overall profitability of your business as compared to your peers or the industry as a whole. This comparison on a percent basis is another example of common sizing.
Gross Margin = Gross Profit/Revenue
$75,000/$100,000 = 75% Gross Margin
Knowing the basic methodologies of Small business analytics and how to analyze an Income Statement can go a long way in both understanding your business and even comparing it to the competition.