When reviewing their income statements, business owners tend to zero in on profits (or losses). But that narrow focus can cause mismanagement and missed opportunities. To get the full picture, you should analyze the entire statement from top to bottom.
Think like an auditor
Approach your company’s income statement with an auditor’s mindset: skeptical, detail-oriented, and evidence-driven. Auditors ask the tough questions and rely on data to identify risks and trends.
Doing the same can help you understand your company’s financial health, spot the key drivers of profitability, and make smarter decisions. It can also reveal fraud and waste before they get out of hand.
Start with revenue
Revenue is the money your business earns from selling goods or services before any expenses are deducted. It’s the top line of your income statement.
Compare your current revenue to previous periods and your budget. Has revenue grown, declined or held steady? Did you hit your sales targets? If not, dig into why. It could be unrealistic goals, internal issues (like losing a key employee), or external factors (like weak demand or a new competitor).
Identifying the reasons for flat or declining revenue is key to improving performance. If you find internal mistakes, remember to treat them as opportunities to improve, rather than problems.
For cyclical or seasonal businesses, compare revenue with the same time period last year or even over an entire business cycle.
It’s also helpful to look at industry trends. If the market is growing but you’re not, it’s likely an internal issue.
If your business offers multiple products or services, analyze your revenue breakdown to identify what’s selling and what’s not. Shifts in sales composition can highlight changes in customer demand. Using this insight, you can make strategic adjustments to marketing, sales, production, and purchasing to align your product with demand.
Evaluate the cost of sales
The line on your income statement includes direct labor, materials, and overhead, aka the costs of producing goods and providing services. The difference between revenue and cost of sales is your gross profit.
Look at how these costs have evolved as a percentage of revenue over time. Ideally, the relationship between revenue and direct costs should remain stable. Fluctuations might reflect changes in input costs or operations. For example, rising wages might be driven by inflation or regulatory changes. You could offset higher labor costs by investing in automation or adding shifts to reduce overtime.
Changes in your revenue base—like more custom work—can also impact your cost of sales. Analyzing gross profit by product or job helps you identify what’s most profitable so you can focus on selling high-margin items.
It is also valuable to compare your company’s cost of sales against industry benchmarks. If your direct materials cost percentage is significantly higher than the industry average, consider negotiating costs with suppliers or finding ways to minimize waste and rework.
Monitor operating expenses
Operating expenses are the essential costs of running your business day-to-day. While they’re necessary to generate revenue, they aren’t directly tied to producing goods or services. These types of expenses include:
- Salaries for managers, salespeople and administrative staff
- Rent and utilities
- Insurance
- Office supplies
- Marketing and advertising
- Professional fees
- Travel and entertainment
- Depreciation and amortization
By closely monitoring these expenses, you can manage overhead more effectively while maintaining profitability.
Many operating expenses are fixed in the short term, meaning they don’t fluctuate with revenue. For example, rent and the salary of your marketing director don’t usually change, regardless of sales. To evaluate your financials, compare the total fixed costs in the current period to the previous one.
Auditors often review each expense line by line and investigate any significant changes, like a $10k or 10% increase. This method helps you ask targeted questions to get to the root cause of unexpected cost increases.
For example, if maintenance costs spike by 20%, a closer look might reveal that you incurred significant, nonrecurring expenses to storm damage repair or, more troubling, potential fraud. You need to dig into the details like an auditor to avoid missing the full financial picture.
Leverage your income statement
Your company’s income statement contains valuable information if you take the time to review it. By adopting an auditor’s mindset can quickly spot trends, identify potential issues, and make better-informed decisions.
Reach out to your Smolin advisor for help interpreting your company’s financials and uncovering growth opportunities.