The analysis of the income statement involves comparing the different line items within a statement, as well as following trend lines of individual line items over multiple periods. This analysis is used to understand the cost structure of a business, and its ability to earn a profit.
A proper analysis of the income statement requires that the following activities be addressed:
Ratio analysis. Several ratios can be extracted from an income statement, each of which reveals different types of information about a business. They are as follows:
- Gross margin. This is revenues minus the cost of goods sold, divided by revenues. It indicates the amount of money earned from the sale of goods and services, before selling and administrative charges are considered. In essence, it reveals the ability of an organization to earn a reasonable return on its offerings.
- Contribution margin. This is revenues minus all variable expenses, divided by revenues. This margin is used to construct a break even analysis, which reveals the revenue level at which a business earns a profit of zero. The break even calculation is all fixed costs divided by the contribution margin.
- Operating margin. This is the profit earned after all operating expenses have been subtracted from the gross margin, divided by revenues. It reveals the amount that a business has earned before financing and other costs are considered.
- Net profit margin. This is the profit earned after all operating and non-operating costs have been subtracted from the gross margin, divided by revenues. This is the ultimate analysis item – can a business earn a profit when all deductions are considered?
Horizontal analysis. This is a side-by-side comparison of income statements for multiple periods. A good comparison is for every month or quarter in a year. Items to look for in this analysis include the following:
- Seasonality. Sales may vary markedly by period, and do so in a regular cycle that can be anticipated. This may result in predictable losses in some periods and outsized profits in others.
- Missing expenses. It can be quite obvious when an expense is not recorded in one period, since there is a sharp drop in one period and twice the usual expense in the next period.
- Tax rates. The tax rate used should be the expected one for the entire year. If the tax rate used is a low one early in the year and a higher one later in the year, then the accounting staff is not using the full-year anticipated rate, but rather the rate directly applicable to each reporting period.
Line item review. Once both of the preceding analyses have been completed, look at the following additional line items for more information:
- Depreciation. Some organizations only record depreciation expense once a year, for the full year. This means that many months have an excessive amount of profit, while the last month of the year is crushed by a large depreciation expense.
- Bonuses. The same issue arises for bonuses as for depreciation. They may only be recorded at the end of the year, even though one could reasonably have anticipated the bonus outcome sooner, and recorded them sooner.
- Pay raises. Some organizations give everyone pay raises in the same month, so a bump in compensation expense is predictable.