The Income Statement: Understanding the financial health of a business - Part 2.
- Clayton Ainger
- Apr 24, 2023
- 5 min read
This is the second training blog of two, which explains the basics of Income Statement analysis. This blog focuses on understanding the financial health of a business shown through income statement analysis, and cost evaluation so you can help your business and your customers.
Here's why you should read this blog.
Leadership and sales excellence means you should be able to discuss the financial health of a business with your colleagues, team, and customers.
Understanding the income statement and being able to do a quick cost analysis will help you to better understand the pressures and realities of running a business, enhance your thinking as a commercial leader and support you in your commercial conversations.
Let’s get into the detail...
Income Statement Analysis - A Quick & Dirty Review
Doing a quick and dirty (Q&D) review of an income statement is relatively straight forward. There are just three numbers you need to explore:
1. Revenue.
2. Operating profit (or loss), and
3. Costs. Specifically cost of sales and operating expenses ie, selling, general and admin.
Here are the steps in order for the Q&D review...
Download the financial statements for the company you work for or one of your favourite customers, then turn to the income statement. It will look similar to image 1, which is an income statement from a large food retailer.
Lets begin with Revenue:
Compare the current revenue figure with the prior year (see image 2). Ask yourself, has it gone up? Gone down? Stayed close to the same? Make a note of the movement.
What can you hypothesize about any movement? What questions could you ask to learn more about the business performance?
If it’s gone up, what could this mean? Similarly, if it’s gone down what could the reasons for this be? Brainstorm some ideas to explore further.
You don’t need to have the exact answers, you just need to be curious about ‘why’ the movement could have happened.
E.g., In image 2 above, revenue has gone up by c.£3.5bn, indicating significant growth from one year to the next. Is this because this company is selling a higher volume of products or services? Have they seen growth in any specific areas? Is it because they are charging more, but selling less volume? Have they made any new company acquisitions whose sales are contributing to the increase?
These types of questions and ideas form the foundation for your commercial conversations.
Next let's look at Operating Profit (or Loss):
Compare the current profit figure with the prior year (see image 3). Ask yourself, was the company profitable this year? Last year? Make a note of the movement.
What can you hypothesize about any movement? What questions could you ask to learn more about the business performance?
If it’s gone up, what could this mean? Similarly, if it’s gone down what could the reasons for this be? Brainstorm some ideas to explore further.
E.g., In image 3 above, operating profit has gone up by c.£1bn. Does this correlate to the increase in revenue? If so, are all their revenue streams profitable or are some loss making? Has there been any reduction in costs, if so, where? Is there a focus on driving efficiency in the business?
Finally, let's do a basic and detailed cost analysis:
In the first instance, there are two cost-lines we are interested in:
Cost of sales (aka Cost of goods sold)
Operating costs i.e., selling, general and administrative expenses.
See image 4.
The first step is to compare the costs figures with the prior year, to notice and hypothesis the reasons any movement before we do a deeper analysis.
E.g., In image 4 above, cost of sales has gone up by c.£3bn - is this movement in-line with the increase in revenue which would be normal or is it for some other reason? Administrative expenses have gone down by £156m at a time when the business is growing - where are they saving costs and/or seeking to drive more efficiency?
Let's explore this in more detail...
...by calculating three different types of profit margins. Specifically,
Gross profit margin
Operating profit margin
Profit after tax margin
Gross profit margin (GP)
The GP margin tells you what a business made (in percentage terms) after paying for the direct costs incurred in the production of a product or delivery of a service. It is calculated as follows:
Gross Profit / Revenue x 100
Operating profit margin (OP)
The OP margin is a performance ratio that reflects (in percentage terms) the profit a business made from running its business operations, before tax and interest. It is calculated as follows:
Operating Profit / Revenue x 100
Profit after tax margin (PAT)
The PAT margin is a performance ratio that reflects (in percentage terms) the profit a business made after all its core business expenses. It is calculated as follows:
Profit after tax / Revenue x 100
Example:
Using image 5 below, calculate the different profit margins for 2021 and 2022 to understand what they mean in more detail:
Answers:
GP Margin = GP/Revenue x 100
2021: £3,776m / £57,887m x 100 = 6.5%
2022: £4,633m / £61,344m x 100 = 7.5%
What do these percentages mean? There are two points to note:
In 2021, this company is making 6.5 pence for every £1 of sales, which has increased to 7.5 pence for every £1 of sales, in 2022.
These calculations also suggests that the direct costs of producing their products and/or delivering their services is costing the business 93.5 pence and 92.5 pence for every £1 of sales respectively.
OP Margin = OP/Revenue x 100
2021: £1,547m / £57,887m x 100 = 2.7%
2022: £2,560m / £61,344m x 100 = 4.2%
When you then take into account the daily running costs of the business, in 2021 and 2022 this company made only 2.7 pence and 4.2 pence for every £1 of sales. Whilst this shows a 55% increase in profitability, the costs of this business still account for 95.8 pence for every £1 of sale.
PAT Margin = PAT/Revenue x 100
2021: £532m / £57,887m x 100 = 0.9%
2022: £1,523 / £61,344m x 100 = 2.5%
Finally, when we deduct finance costs and taxation, in 2021 and 2022 this company made only 0.9 pence and 2.5 pence for every £1 of sales, respectively. This suggests that in 2022 it costs the business 97.5 pence for every £1 earned.
So, you can see from this example the impact that costs have on a business, and hopefully appreciate more the importance of cost and cash management.
EXERCISE 1: How can you use this information to improve your financial performance & that of your customers?
For your business:
If small changes make a big difference, what is the one thing you can do to help improve the financial performance for your business?
For you customers business:
How can your products or services help save your customers between 1% and 5% of their cost base? What would it mean for your customers business? How much extra profit and cash would this give them? What could they then do with this cash?
I challenge you to find out by asking them...
EXERCISE 2: Its time for practice and play...
Download the financial statements for your top five favourite customers, whose businesses you are familiar with. Then complete a review of their revenue, costs, and profitability.
Thank you for reading our blog.
Enjoy a wonderful day!
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