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Income statement analysis
March 03, 2018
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:
o 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.
o 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.
o 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.
o 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?
o 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.
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