What do you do with your financial statements after your CPA delivers them? If you’re like most business owners and managers, you breathe a sigh of relief that they’re finished, file them away and go back to running the business. But financial statements can be a useful tool to help improve business operations in the future.
Eye on profitability
The income statement is a good starting point for using your financials to analyze performance and remedy inefficiencies and anomalies. Here are four ratios you can compute from income statement data:
1. Gross profit margin. This is calculated by dividing profit after direct costs by revenue. It’s a widely used ratio, measuring a company’s ability to cover the direct cost of sales.
2. Net profit margin. This is calculated by dividing net income by revenue. If the margin is rising, the company must be doing something right. Often, this ratio is computed on a pretax basis to accommodate for differences in tax rates.
3. Return on assets. This is calculated by dividing net income by the company’s total assets. The return shows how efficiently management is using its assets.
4. Return on equity. This is calculated by dividing net profits by shareholders’ equity. The resulting figure tells how well the shareholders’ investment is performing compared to competing investment vehicles.
Profitability ratios can be used to compare your company’s performance over time and against industry norms.
Connecting the dots
If your company’s profitability ratios have deteriorated compared to last year or industry norms, it’s important to find the cause. If the whole industry is suffering, the decline is likely part of a macroeconomic trend. If the industry is healthy, yet your company’s margins are falling, it’s time to determine the cause and then take corrective measures.
Depending on the source of the problem, you might need to cut costs, lay off unproductive workers, automate certain business functions, eliminate unprofitable segments or product lines, raise prices — or possibly even investigate for fraud. For instance, a hypothetical manufacturer might discover that the reason its gross margin has fallen is rising materials costs because its procurement manager is colluding with a supplier in a kickback scam.
Today’s uncertain, inflationary markets are putting the squeeze on profits in many sectors. But don’t accept that excuse without first investigating further. Your income statement provides critical clues into what’s happening at your company.
Examine the main components — gross revenue, cost of sales, and selling and administrative costs — to assess if specific line items have fallen due to company-specific or industrywide trends. Also, monitor comparable public companies, trade publications and the internet for information. We can help you determine possible causes and brainstorm ways to unplug your profit drains.