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Wednesday, November 11, 2015

What Do My Financial Statements Mean? - The Income Statement

This is the second post in a series of posts dealing with your year end financial statements and what they mean. In Monday's post, I talked about the balance sheet. Today, I am going to talk about the statement that most of you understand the best: the Income Statement, otherwise known as the P&L or Statement of Profit and Loss.

What Does the Income Statement Tell a Reader?

The most obvious piece of information that the statement conveys is how much money your business made of lost during the period. However, what is not obvious to many non-accountant readers is that this measure is not necessarily the amount of cash profit available for distribution. The reason will become more apparent as you read through the post. However, there are many other useful insights that can be communicated about a business with this statement:

  1. It can show whether or not the current performance was due to normal business events, or whether it was due to unforeseen, one-off events and circumstances outside the control of the business. 
  2. It will show what kinds of gross profit the business is generating on sales of goods or provision of services. 
  3. It can enable the reader to calculate the relationship between key expense items that can be compared to some objective standard to determine the viability of the business. 
  4. It can show the kinds of investment being made by the business in activities that are crucial to the long-term viability of the business, while not being immediately urgent. 
  5. It can show whether or not the profit or loss was significantly influenced by transactions with entities that the business is related to and is therefore not dealing with at arm's-length. 
I will now discuss each of the above in more detail with examples

Normal Business Events Versus Freak Occurrences

When a reader of the income statement sees an unusually high profit or an unusually high loss for the period being reported, they will naturally wonder whether or not such a performance is likely to be repeated. To determine this, they will want to know if there were any non-recurring events that occurred that were outside the normal course of business, not within management's control that had a significant financial impact on the performance of the business. 

This is accomplished by showing such items in a separate section of the statement. For example, a loss due to some catastrophic event, such as a fire, would be presented as an other item rather than simply being buried in income and expenses. The historical cost of the assets destroyed, as well as all the related costs of cleanup and reconstruction would all be reflected in one line item "loss from fire". In this way the reader can evaluate how the business has performed independently of these types of events. Other examples of events and circumstances that would lead to ordinary item disclosures:

  1. Legislative changes that render certain activities of the business illegal so that they must be immediately discontinued. In this case, the entire portion of the business operation that related to the now discontinued activity would be separated out from the rest of the statement and presented separately in this section. 
  2. Gains and losses on the disposal of capital assets of the business. Although these are at management's discretion, they only occur infrequently and would distort the annual performance of the business if not separated out. 
  3. Windfalls such as an unexpected damages award on a court case that the business was fighting. 
  4. Significant losses from theft.
  5. Significant losses from the bankruptcy of non-trade debtors - companies or individuals that the business advanced money to that they were not selling goods or providing services to. The inability to collect normal trade debts is considered a normal cost of doing business. So those types of losses would not normally be presented as other items. 

Gross Profit

Gross profit is simply the difference between revenue and:

  • Cost of sales for a business that sells inventory, and
  • Service delivery cost for a business that provides services
The reason why this measure is important is that a sophisticated user can use it to quickly determine the long-term viability of the business/ 

What does the user look for in this case?

Most of the overhead expenses that a business has that are not directly related to the product or service offered are fixed in the very short term. Some of the expenses can be curtailed over the medium term, but in the very short term they are all fixed. Gross profit is the only way that these expenses can be covered. 

So if a reader knows what the total overhead expenses of a business are, and they know what the gross profit is they can get a sense of how close the business is to breaking even. This provides some measure of the risk associated with the business. If the reader has some idea of what the volume of business is on a comparative basis, then they will be able to further determine whether a potential shortfall in profit is a problem that can be solved by increasing business volume, or whether it requires an increase in the gross profit percentage. 

A reader that is very knowledgeable about the industry you are operating in will know whether the market conditions are such that you can increase prices or reduce costs to achieve a better gross margin percentage. How? By analyzing the performance of your competitors. Thus they will be able tell whether a business facing losses can actually turn its situation around or not, or at least what it has to do for that to happen. 

Relationship Between Key Income Statement Items

It is generally accepted within the restaurant industry that food and labour should generally not exceed two-thirds of revenue for a viable restaurant operation. So as long as the income statement for a restaurant discloses non-owner labour and food separately, it will be very easy for a bank or a prospective investor to determine whether the restaurant represents a good risk or not. 

Each industry has its own key performance indicators that investors look at when evaluating a business. Many of them will be a cost expressed as a percentage of revenue, such as salaries, or total fixed overhead. 

The key here is to ensure that your statements contain enough line detail to enable a reader to calculate these relationships. Your accountant should be able to tell you what these relationships are that your bank or investors are looking at and then work with you to make sure that your financial statements are set up in such a way that this information can be provided. 

Non-Urgent But Crucial Activities

There are many activities that are important to the long-term viability of a business that nonetheless are not immediately urgent. Some examples include:

  1. Adequately maintaining equipment and buildings.
  2. Carrying adequate insurance.
  3. Investing in professional development and training of staff. 
  4. Advertising and business development.
  5. Research and product development.
  6. Offering warranties to customers on the product sold. 
The easiest way for a banker or investor to tell whether or not a business is doing the above things is by looking at what they are spending in each of the above areas. If the related expenses do not appear on the income statement then that tends to suggest to a reader that a business is cutting corners in these areas. 

Still there are other activities that are considered to be desirable from a social point of view and many investors look for evidence that a business is engaging in these activities. Examples would include:

  1. Making donations as a way of giving back to the community.
  2. Making provisions to clean up or restore a property after use for some hazardous activity such as a mine or a refinery. 

Consequently it is important if you are having external financial statements prepared by an external accountant to ensure that the statements present the following separately if you are having other parties looking at your financial statements:

  • Repairs and maintenance costs. 
  • Insurance expense.
  • Professional development and training expenses.
  • Advertising and business development costs.
  • Research and product development expenses should not be buried in labour, materials and overhead as is so often the case. 
  • All donations should be reflected, not just those made in cash. 
  • Amounts set aside to honour warranties. 

Related Party Transactions

Sometimes a business will conduct transactions with businesses that are related to it, usually because both businesses have the same owners. In these cases, one would expect that the terms and conditions of the transactions would or could be significantly different than what they would be if the business were dealing with an unrelated party. Sometimes the concern is with whether the transaction would have occurred at all in the absence of the relationship. 

For example take a business that has $100,000 profit for the year. Sounds pretty good right? What if you found out that the day before year end the business made a $200,000 sale to a company that it owned. All of the sudden things don't look so rosy do they? In this example the business likely would have had a loss were it not for this 11th hour transaction that it essentially controlled. As an investor or banker you would want to know about these kinds of transactions so that you could determine what the true performance of the business was outside of these types of transactions. 

A well prepared income statement will either show these transactions separately on the face of the statement, or they will be disclosed in a note to the financial statements that is referenced back to the relevant line items on the statement. 

Cash Versus Non Cash

I said at the beginning of this post that the profit or loss shown in the income statement is not necessarily the amount of cash available to distribute, or the amount of cash lost during the period. There are several expense items included in most income statements that are non-cash in nature. They are non-cash in the sense that the cash outlay for them will come at some future point in time. Examples of such non-cash items are:

  • Amortization of capital assets, otherwise known as depreciation. The cash outlay will come when the related assets are actually replaced. 
  • Gains and losses on disposals of assets or investments. Gains and losses are simply the difference between the amount of cash received and the historical cost of the item disposed of. Therefore gains and losses are non-cash items. 
  • Provisions made for warranties. The cash outlay comes when the warranty is actually honoured.
  • Provisions made for legal costs in a court case. 
  • Provisions made for site cleanup or restoration. Again the outlay comes when the site cleanup or restoration is actually carried out. 
That concludes my post about the income statement. Tomorrow, I will move on to the Statement of Cash Flows and then on Friday, I will talk about the notes to the financial statements. 

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