Thoughts about the income statement
This section covers my thoughts and reflections on the income statement.
Below the general remark on how to understand your income statement, you'll find links to further articles covering each line item in particular.
Understand your income statement
Understanding an income statement and being able to derive meaningful conclusions is crucial. The analyses can tell you a lot about your changes in profitability, increase in revenue, or abnormal changes due to specific events (e.g. Covid-19 pandemic).
In this article, I am going to share why it is important to perform a high-level analysis of your income statement and what to look for.
Assess the historical performance
To assess the historical performance, it is paramount to look at the EBIT or EBITDA as a number and as a percentage of revenue (or total output, depending on the company). This helps understand the stability of the business.
In general, to assess the historical performance, I tend to look at ratios first, e.g. costs as a percentage of revenue, profit as a percentage of revenue. This helps me understand if there have been major distortions or not. I also check the growth rates. If revenue increased from 100 to 110 from Year0 to Year1, but then from 110 to 500 in Year2, then this certainly deserves further analysis. If that’s the case, did costs also increase accordingly?
If there is any publicly available information on the latest developments, then you can also use this information. Let’s say, the owner states that she/he fired 50% of the employees two years ago. However, personnel expenses remain the same. Then something’s off or needs to be clarified.
Identify the main drivers
What drives the bottom line? Two aspects need to be considered. First, external factors. And second, internal factors.
External factors mostly relate to top-line development. Revenue can be impacted by a crisis, by a shutdown of a plant, or — for content creators — by a long sick leave that stops you from creating more content. But also on the cost-side external factors can impact the cost of raw material (e.g. fluctuations in oil price).
Internal factors mainly relate to efficiency and “abnormal situations”. Imagine a firm that hired 100 new employees. It will take time to familiarize them with the processes and standards. Slowly, productivity will improve. It might take a new employee two hours at first but slowly go down to one hour. Abnormal situations cover one-off payments (severance payments, hiring bonus) or one-off revenue that distort the picture.
Overall, when looking for the main drivers, we want to understand why the result is as it is. Was it mainly driven by a higher/lower topline? Or was it affected by costs? And if so, why?
Present a sustainable picture
Keeping these aspects in mind, it is crucial to present a sustainable picture, as there will be a comparison of past and future development. One-off items or “abnormal situations” distort the picture and don’t allow for a comparison. Let’s say, there has been a severance payment last year of 50. Everything else was normal course of business. Then, we would need to remove the 50. By this, we only present the normal course of the business (“as if everything was normal”, as-if view). This is important because, for the planning process, an as-if view is required, as well — unless you want to plan one-off items (which wouldn’t be one-off then anymore).
- Assess margins and historical development
- Identify what drives the bottom-line
- Present a sustainable picture
...stay tuned, more to come