Interpreting the Income Statement

How do you read the income statement? How do you know what it's telling you?

The income statement is like a history book, presenting to you the story of what's happened to your business over a specific period. That period will be shown near the top of the statement, where you'll place the phrase, "For the year ended xxx," or something similar. This phrase allows you to quickly identify in which period the revenues and expenses occurred.

You'll find that reviewing income statements is most useful when you look at more than one period together, so that you can see each period in relation to others. It's one thing to know that you had net income of $50,000 this year, but it makes a difference whether last year you made $25,000 or $110,000. It's the trend you're interested in here. In what direction is the net income heading?

Here are some issues to address when looking at the income statement:

Is your gross margin the same as last year? If it's lower, it could mean that you're selling more goods than last year but at a lower profit margin. This would be your signal to examine your sales and supply practices more closely. If your gross margin is higher, you need to understand why. Did you find a new supplier this year who sold you your materials for production at a lower cost? You may have permanent savings from such an accomplishment. Did you substitute cheaper-quality goods for your usual goods? If so, you will want to make sure your revenues are just as high as always and that you are not facing major customer dissatisfaction.

Are your administration expenses growing? If you moved into larger premises in the current year, you need to make sure that the move is producing the results you were expecting. For example, if by moving to your new showroom right on the highway you expected to increase revenues by 20 percent, did that increase occur? Measure the results by looking at the increase in revenues since the date of the move compared to the same time frame the previous year.

Have the revenues from your main product line decreased dramatically this year? If the answer to this question is yes, you must find the cause. Has a newer product come onto the market, taking a bite out of your sales? Has demand for your product declined in general, either through changing consumer tastes or swings in the economy? You must hunt down the underlying reasons for the change.

You can see that the income statement will, if you let it, provide you with valuable information to help you run your business. Much like the reflectors on a dark highway, it can show you where the road is and warn you when you're going to veer off. However, I will once again caution you that it's also important to look at all three financial statements together - the income statement, balance sheet (discussed in the previous session), and cash flow (discussed in the next session). They each provide a different piece of the story, and their interrelation provides the subplot.