This is the first in a series of articles to help businesses better understand their financial statements and how they can be used to help you run your business, make better business decisions, and plan for growth.
We talk a lot about running a business by the numbers. It’s a great exercise to take some of the gut feelings you have about your company and putting them to the test against actual financial results. One of the sometimes-overlooked starting points in this endeavor is understanding how financial statements are laid out, and where might you spend your focus upon review.
Let’s talk about the income statement. First off, there are a ton of ways to get very technical with different reporting requirements – this is not that kind of post. I’m speaking to owners of small or medium sized businesses trying to gain a basic understanding of what’s going on here.
There are four basic parts to the income statement:
- Cost of Sales
- Operating Expenses
- Other Income or Expense.
Revenue sounds pretty straightforward, but right away there are some things to be aware of. For starters, does your accounting system show your net sales or gross sales on a financial statement? Gross sales is the unadjusted sales price of your product or service. If I charge $10 for my widget, and I sell one, I have $10 in gross revenue. Net sales will take certain discounts or other adjustments into consideration. If I normally charge $10, but I run a $1 discount promotion, my gross sales are still $10, but my net sales are $9. The question you should know the answer to is which one is showing up as revenue on your income statement.
Cost of Sales
Cost of sales, also referred to as cost of goods sold, will follow immediately after the revenue section. These are typically variable costs that have direct correlation to the sale of your product or service. Things like warehouse labor, product materials, or tools or equipment used in creation of your product, are all expected to appear here. Because this section scales with your revenue, it is an extremely valuable area to spend your time in reviewing. This is often the place where owners have the biggest gap between expectation and reality. Resist the urge to denounce the numbers as being incorrect, if you have accurate reporting then the most likely cause for discrepancies between expectations and actual results are:
- The expectation is unrealistic and needs to be reimagined or
- The execution of the expectation needs work and this is a great opportunity for improvement.
The next section is operating expenses. These are typically overhead costs required to support the sales and cost of sales parts of your company. You’ll see a lot of things in this section, for example office salaries, office rent, office supplies, travel – things of that nature. To simplify this section, these are generally expenses that do not scale with sales in the short-term, and if you stopped selling products today you would still have most of these costs tomorrow. In my opinion, this area is often a trap for business owners trying to be more profitable. It’s easier to look at office supplies and assume it’s probably not being done as absolutely efficient as possible because your office manager takes too many trips to Trader Joe’s, than it is to dig into cost of materials. Who cares though? Unless you’re really wasting serious money, how much can you expect to save on office supplies or employee lunches? If something is really egregious in this area, then an ideal path may include getting your office manager involved and reducing the expense to a more reasonable level. It is not worth your time as an owner to spend a lot of hours here.
Other Income and Expenses
The last area on an income statement is other income and expense. This is usually pretty small and reserved for line items that don’t fit anywhere else. Things like interest income on checking account balances, or extraordinary expenses that are not recurring and are not part of the core business may show up here. Again, this is typically not an area where you will get a lot of value for your time.
We’ll talk more about understanding the income statement in future posts. For example, and I have alluded to it here quite a bit, where is the most value going to be achieved when analyzing these accounts? How do we quantify our gut feelings and measure them against results? How much detail is appropriate, do I want ten revenue line items or one? We’ll also be getting to the balance sheet as well, which is often overlooked but can have major impact on forecasts and planning.