My last post began the climb to a higher understanding of your income statement and how to use it to make more money. This post takes us to the next rung on the ladder of income statement intelligence by presenting some basic P&L analysis. By the end of it, you will know how to tell if the products or services you’re selling are profitable or if you’re losing money on them. You can then take action on the troublemakers to increase your bottom line.
If you’re an owner or manager, this kind of analysis is critical to your success and should not be delegated away. If you suffer from arithmophobia (a real word meaning fear of numbers or arithmetic), don’t let it get the better of you and read on with me.
Now let’s do some analysis. Let’s assume this is our income statement in dollars.
Immediately we can see we’re a $3,000,000 company (refers to our revenues) and we’re profitable (net income is $240,000). But looking at these numbers on their own in a vacuum just tells us the SIZE of our company’s revenues and expenses and whether the company’s profitable or not. So to know more, we present each line item as a percentage of sales as follows:
Here’s where things get interesting. Now we can see that of every dollar of sales, 40 cents goes to expenses directly associated with purchasing and delivering the goods or services we’re selling (i.e.; cost of sales = 40%). What’s left is gross profit, called gross because it’s before deducting operating expenses as opposed to net profit, which is after deducting operating expenses. Gross profit must be enough to cover operating expenses and other expenses such as interest expense and still have some left as our profit. Gross profit as a percentage of sales is the most CRITICAL of income statement ratios for managing profitability and is called Gross Margin.
Here’s why it’s so important a ratio. It helps us determine if the products or services we’re selling are profitable enough on a gross basis to cover our overhead and leave us with our desired profit. If we source a new product that will give us gross margin of 40% knowing that our operating expenses cost us 48%, then we should reject such product.
If we look at the gross margins of individual products or services that make up our product line, we’re likely to identify some that do not earn sufficient gross margins. These should be addressed immediately. If our overhead has been streamlined as much as possible and can’t be reduced materially, then either we can increase the sales price, reduce our purchase cost, or discontinue the product.
Another important income statement ratio is net margin, which is net income as a percentage of sales.
Let’s say we want to earn a net margin of 10% of sales next year. How much must our gross margin be to allow us to earn a 10% net margin? Working backwards, let’s calculate it.
This means that our Cost of Sales can’t be more than 38% of the sales price to yield a gross margin of 62%.
Let’s say that our cost of sales is composed of the following:
If we know that shipping costs us 10% of sales, and we need a total cost of sales percentage of 38% to make our gross margin of 62% and net margin of 10%, then our purchase cost of goods cannot exceed 28% of sales price.
So if we have a product we can sell for $10, we can’t pay more than $2.80 for it (28% purchase cost). Otherwise, we’ll lose money on each sale and no amount of volume will make this product tolerable. The more we sell of a losing product, the more we lose. This is valuable to know and should inform us in pricing our goods, negotiating prices with vendors and deciding which products to keep and which to drop.
So thus far, the key takeaways are to know how your income and expense accounts are grouped in your income statement and the percentage each line item in your income statement bears to sales (i.e.; your margins). Make sure your income statement groupings are consistent with your industry’s practice and are informative enough to run your business. If you have any questions, ask the CFO.
In my next post, we’ll delve a little further into how income statement analysis can make you more money. In the meantime, do you know what’s in your margin?