Overview – What do they tell you? Part 1
a few years ago I wrote a white paper on understanding how to read financial statements for non-financially trained CEOs and business owners.
https://financialsoft.biz/white-paper-understanding-financial-statements/
This article is a supplement to that white paper providing a broader view of financial statements and what each statement tells you about a business. This article can be read before or after the more detailed white paper.
We have three financial statements to consider here: the Income Statement Part 1 (often called the Profit and Loss statement), Part 2 the Balance Sheet, and the Cash Flow Statement.
Income Statement
The Income Statement is the most commonly understood Financial Statement – as it should be. It is the statement that really tells you about the operations of the business from the top line of sales (revenue) to the bottom line of Net Profit.
The top line of sales measures the total income a company generates from its operations – supplying a product or service to their customers. If the top line is not doing well there is little else you can do about its impact on profits other than reduce the costs of the product or services or reduce expenses. Expense reduction, which could mean reducing your work force, may be an undesirable result of a bad top line. Most companies emphasize driving their top line (sales) as their prime focus because of the overall positive impact on the complete operation.
The income statement also measures a company’s Cost of Goods Sold (COGS), or Cost of Sales(COS) as it is sometimes called. COGS determines the Gross Margin of a business. It is the measure of what it costs to provide your product or service – the larger the gap between sales and COGS, the greater the gross margin. If COGS is too close to the Sales price of the company’s product, a small price reduction to close a deal could cause a negative gross margin. So a smart company will place a lot of attention on keeping its COGS as low as possible.
The final part of the income statement measures all your expenses during the measured period of time for the statement. This is a very big category that includes Salaries, Rents, Leases, Business Expenses, and Utilities to name a few. These expenses generally remain the same regardless of sales. Again, poor sales with high expenses can result in no profits, or in the worst case – losses.
Large companies like the one I came from only measure performance of product groups or divisions by the income statement for each group or division.. I now realize managing by the income statement alone can be a major mistake for any companies as the result can be disastrous to cash flow.
One of the potential adverse consequences from making decisions based on the income statement alone is related to the top line of sales.
In an accrual income statement, sales only tells a company that an order has been fulfilled. It does not mean the customer has paid for the product or service. Many companies give their customers a line of credit to pay the company for what is delivered. Often that allows 30 to 45 days to pay. As a result of this payment delay, a company cannot spend what they think they have in cash as the sales line does not represent actual cash received. The net profit is not real either, as it is directly related to that sales line. A company can only spend what is reflected in it’s the Balance Sheet – the next financial statement we will discuss.
I would recommend you read Part 2 of this article plus my white paper found here to get more details beyond the simplified overview in this article.
https://financialsoft.biz/white-paper-understanding-financial-statements/
Recent Comments