The Income Statement, as we know, shows a business’s financial performance over a period of time by summarizing all items of income and expense. For an Owner or Manager, this document helps determine current financial health, predict future opportunities, decide on business strategy and set goals for the management team.
Additionally, the Income Statement is an important document to lenders when it comes to evaluating credit worthiness, covenant compliance and overall financial health. If you are an Owner considering either selling your business or acquiring another, the Income Statement will probably be the first document requested during due diligence, and the leading indicator of value.
To be effective, the Income Statement must be structured and prepared in a way that tells the story of your business in a relevant and timely manner. The discussion that follows summarizes what we consider to be best practice and applies to any sized business and industry.
The Income Statement should be structured to align with the primary business activities, with adequate granularity on individual line items of revenue and expense within each functional grouping. For instance:
- Revenue from sales activities
- Cost of Sales from production and procurement activities
- Distribution and delivery to move product to the customer
- General and Administrative expenses such as human resources, quality assurance, sales management and general management
The groupings above should also align with the company’s organizational structure to promote accountability. For instance, sales management takes “ownership” of the revenue section of the Income Statement; production and procurement management is responsible for the cost of sales section; transportation management owns the distribution and delivery section; and the various department heads are accountable for the general and administrative section.
Within each functional grouping, segregate variable costs (those that fluctuate proportionately with volume) from fixed costs (that will generally not fluctuate). In this way you will be able to calculate important metrics such as:
- Contribution Margin, defined as revenue less variable expenses, ideally expressed on a per unit basis, which quantifies the impact to profitability of one additional sales unit, and
- Break Even, the amount of product that must be sold to cover fixed expenses, calculated as total fixed expenses divided by contribution margin
For each line item of revenue and expense, also express the total dollars as a rate per unit sold or produced (as appropriate) or as a percent of revenue. The absolute dollars don’t always tell the story, particularly for variable costs. Ideally, track the revenue or cost per unit as this is a better indicator of underlying revenue and expense performance.
Link to Key Performance Indicators (KPIs)
Prepared in this manner, the Income Statement should effectively link itself to KPIs developed by functional area, and in certain instances line-item detail. The management team will be able to clearly see how their daily actions to continuously improve KPIs in turn impact revenue and expense line items.
A complete and accurate Income Statement should be available no later than the 10th working day following the close of each month, and earlier if possible. Later than this, the information loses value as a decision-making tool. Invariably, businesses that cannot meet a 10th working day of the following month closing schedule have inefficient back office processes that require overhaul.
As a management tool, the Income Statement can provide valuable insight into overall performance by comparison to either:
- A budget, which establishes your expectations of how much profit the business should be returning for the capital invested, and/or
- Similar businesses through either publicly available information or via industry associations
The Income Statement is a critical financial document and an effective management tool, if prepared properly and in a timely manner. It establishes goals, measures performance and tells the story of the business in financial terms. Contact the experts at The Roebuck Group for help in optimizing your financial reporting.