2.03 – Becoming an “Active Reader”
When presented with an income statement, it’s crucial to be an active reader. Instead of passively skimming through the numbers, engage with the information and ask questions to better understand the business’s financial health.
Being an Active Reader
An income statement only fulfills its purpose if you actively analyze the numbers and inquire about the business’s performance. Start by examining the size of the business and comparing profit with sales revenue for the year.
For instance, profit (net income) is what remains from sales revenue after deducting all expenses. Suppose a business generates a $4.482 million profit from $71.064 million in sales revenue, resulting in a 6.3% profit margin. This indicates that 93.7% of sales revenue went to covering expenses. A 6.3% profit margin is acceptable for many businesses, though profit margins can vary significantly across industries.
Key Questions to Ask
- How does profit compare with sales revenue?
- What is the profit margin?
- How do expenses impact the profit margin?
Expense Disclosure Practices
Accounting standards do not mandate the disclosure of specific expenses on the face of an income statement. For example, the amount spent on advertising doesn’t have to be disclosed. However, public companies must adhere to SEC rules, which require disclosure of certain expenses like repairs and maintenance.
In the technology business example, expenses such as professional fees, corporate labor overhead, and advertising are included under selling, general, and administrative expenses. Some companies disclose specific expenses like advertising, marketing, research, and development, but practices vary.
Evaluating Profit Performance
To assess a business’s profit performance, consider these benchmarks:
- Industry-Wide Performance Averages: Compare the business’s performance to the average performance within the industry.
- Competitors’ Performances: Analyze how the business’s profit margins stack up against immediate competitors.
- Historical Performance: Look at the business’s performance over recent years to identify trends.
- Internal Forecasts: Compare actual performance against the company’s internal forecasts for the same period.
By being an active reader and asking these critical questions, you can gain a deeper understanding of the business’s financial health and performance. This approach helps you make informed decisions based on the income statement’s insights.
