In our previous post we presented readers with the income statement of the fictitious ABC Corporation duplicated above.  In that entry we gave a brief explanation of each of the items on the income statement that may be helpful to review before proceeding further into this post, which is aimed at teaching you to analyze the income statement for information about the financial situation of a business.

Let’s start our income statement analysis by calculating a very important financial ratio, gross profit margin (also known as gross margin).  The math here is about as easy as it gets, gross profit margin is equal to gross profit divided by total revenue.  In ABC’s case we come up with a gross profit margin of 0.60 or 60% ($90,000/$150,000).  Gross profit margin can be thought of as a measure of efficiency, it tells us how much money is left over from sales after accounting for the cost of the goods sold.  While average profit margins vary greatly from industry to industry, as a general rule a higher gross profit margin indicates a more efficient company within its field.

The next figure we want to calculate is operating income or operating profit, as it is sometimes referred to.  Once again, the math is simple: operating income is equal to gross profit minus operating expenses ($90,000 – $5,000 – $45,000 = $40,000 in our example).  Operating income puts a dollar figure on the amount of money that a business is generating from its core activities and is closely watched by lenders and investors as a gauge of a firm’s ability to repay loans or pay dividends to investors.  If a business is experiencing growth in its operating revenues, then it will have more money available for expansion, debt repayment, or any other management initiatives.  The converse is also true of course, so if your business’s operating income has been steadily declining this should give some cause for concern.

Now let’s go ahead and calculate ABC’s operating margin, which is equal to operating income divided by total revenue ($40,000/$150,00) or 26.67%.  Operating margin tells us how much a company keeps from each dollar of sales, before it has to pay interest and taxes.  As with profit margins averages will vary among different industries, but the higher the figure, the better.  Looking at your company’s operating margins over time, by comparing different years’ income statements, can be an effective tool to measure how effective your firm is at keeping what it earns in sales revenue.  If your revenues are increasing but your margins are shrinking, it may be time to assess whether those additional revenues are worth the money it costs to acquire them.

So hopefully now you have an idea of what the income statement can tell you about your business and how to calculate some simple, yet important, ratios that will also be of interest to lenders and investors. As with our discussion of balance sheets, this series on the income statement is not meant to have been an exhaustive analysis.  We have left out a discussion of some of the more complex items that can appear on the income statements of large corporations, such as amortization and depreciation, although we may cover these in future posts. In any event you should now have the tools to understand a good deal about your own company’s income statement, and if you wish to read further, we’d once again recommend an introductory undergraduate or MBA-level financial management textbook.

We recently wrapped up our two-part piece on balance sheets, and today we are going to move on and start taking a look at the next financial statement on our list, the income statement, also called a “profit and Loss Statement”.  Unlike the balance sheet, which looks at a company’s financial position at a specific moment in time, the income statement reflects performance during a period of time, typically a calendar year or quarter.  Let’s continue with our fictitious ABC Corporation and have a look at its income statement below.

As with our sample balance sheet, your company’s income statement will not look exactly like this one (it may be missing some of our entries and contain some additional line items), but it should follow the same general pattern.  It will start with a figure labeled total revenue or perhaps net sales—which is essentially the same thing—at the top, and then break down various expenses before concluding with a net income (or loss) figure on the bottom line.  This is why people often refer to a company’s profitability as “the bottom line”.

Let’s go through ABC’s example line by line and see if we can start to get an understanding of some of the major items that you can except to see on an income statement.

Total Revenue (or Net Sales) – This is pretty straightforward; the figure represents the total amount of money that the business brought in for the period covered by the income statement. If the company has any other income streams, they will also be listed, such as interest income, income from investments, or other income.

Cost of Goods Sold (COGS) – COGS tells us how much money we spent to acquire and produce the goods that we sold to generate the revenues included in the line above.

Gross Profit – Is equal to total revenue minus COGS.

The next section of our income statement breaks down a group of costs known as operating expenses, which include things like salaries, office supplies, and other items that are essential to the day-to-day functioning of a business.  If an expense can’t be included under COGS (i.e. it is not directly related to the production of a good or service) then it should appear as an operating expense.  ABC’s operating expenses are divided into the following two entries.

Research and Development (R&D) – These costs are often thought of as those that pertain to the future of a business, such as the testing and development of a new product or prototype.

Selling, General, and Administrative Expenses (SG&A) – This broad category encompasses all of a firm’s personnel costs (salary, benefits, and the like) as well as things like advertising and travel expenditures. Sometimes these and other like expenses are detailed out as separate line items.

We now move on to the operating income section of the income statement, which in our case contains these four items.

Earnings Before Interest & Taxes (EBIT) – This figure shows us a company’s total profit before accounting for interest and taxes that it has to pay.  Although this may not seem like a useful metric, and indeed there are many who argue that it is not, because everyone has to pay taxes and all borrowers must pay interest on their loans, some people find it helpful to isolate a company’s ability to generate profit and to compare similar companies with different tax rates and barrowing habits.

Interest Expense ­– The amount of money that a company pays as interest on its loans during the period covered by the income statement.

Taxes – We’re all familiar with this one, on the income statement the figure represents the total tax bill for the period and is sometimes expressed as a percentage (i.e. a tax rate) as well as a dollar figure. S-corporations, remember, do not pay taxes, but rather pass the tax liability through to the shareholders.

Net Income – Often referred to as a company’s “bottom line” because of its position on the income statement, net income is what is left over from total revenue after subtracting all expenses.

That brings us to the end of ABC’s statement and of this week’s post.  Next week we’ll dive deeper into how to analyze and interpret the income statement.

In our previous HBS entry, we introduced readers to the balance sheet of the fictitious ABC Corporation presented above.  At the time, we gave a brief explanation of each of the items on the balance sheet that you may want to review before diving into this post, which is aimed at informing you how to “read” a balance sheet for information on the financial condition of a business.

Before we get into the nitty-gritty of balance sheet analysis let’s revisit something we raised at the end of our prior post: the fact that for all businesses total assets are equal to total liabilities plus equity.  Now that you know what is meant by assets, liabilities, and equity, this equation should make intuitive sense.  If ABC Corp. were to sell off all of its assets it would receive $50,000; if ABC pays off all of its liabilities it will have to shell out $38,000 leaving it with $12,000, which is equal to the company’s total common equity.  Thus we see that assets minus liabilities equal common equity, and some simple math then tells us that total assets are equal to total liabilities plus equity. Common equity is what is left when liabilities are subtracted from assets and is therefore sometimes referred to as the net worth of a company.

So what exactly can a balance sheet tell a small-business owner?  It can help you to gauge the financial health of your company and to analyze trends that may be occurring over time.  It is also one of the cornerstones of financial reporting that lenders and investors will want to analyze before deciding whether or not to provide funding to your business.

One very important figure we can calculate is the current ratio, which is equal to current assets divided by current liabilities; in our example $35,000/$18,000 equals a current ratio of 1.94.  Because the current ratio measures a company’s ability to pay its short-term liabilities, it is a favorite of banks and other lenders. While current ratios will vary from industry to industry, a rule of thumb for small businesses is that lenders like to see a current ratio of at least 2.0.

Because inventory typically represents the least liquid of a firm’s current assts, we also want to gauge short-term financial health without relying on converting inventory into cash.  We accomplish this by looking at the quick ratio, which is equal to current assets minus inventories, divided by current liabilities. A company’s quick ratio (in our case ($35,000-$10,000)/$18,000 = 1.39) will obviously be lower than its current ratio but it will hopefully be greater than 1.0, meaning that it can pay off its current liabilities without having to worry about selling its inventory.

Because it represents a picture of a company’s financial situation at a specific moment in time, a single balance sheet is not useful for analyzing trends.  In order to do this though, we simply have to look at two or more balance sheets and see how things have changed over time.  For example, are your inventories growing much faster than your revenues?  If so, this may be a sign that you are stockpiling too much product at the expense of more liquid assets like cash.

You’ll also want to keep a close eye on how your receivables change over time.  If they are increasing faster than your revenues, then you may need to improve your collections process and take a realistic look at who owes you money and how likely they are to pay it back.  If you find that you have one or two problem customers, it may be time to have a talk with them.

Hopefully you now have an idea of what your company’s balance sheet is all about and how to read if for clues as to the health of your finances.  While our discussion has been by no means comprehensive, it should have left you with an understanding of some of the most important information that a balance sheet contains.  For even more detailed analysis, a college or MBA level financial management textbook can be a great resource.