An income statement should be analyzed prior to budgeting, to identify trends in income and expenses. If abnormal expenses are incurred, the business will suffer major setbacks. On the strength of this information, appropriate planning can be made for the future.
A income statement evaluation is performed as follows;
The main income component from service or product. A business however cannot rely on one source of income only. Most bigger corporations, continually strive to diversify their services. It is unwise to stick to one type of service only. Three sources of income would be ideal for the growing small business. I like using the cost accounting model of main product, by-product and waste product as an example. An astute furniture manufacturer, would exploit additional opportunities, over and above normal furniture sales, to sell by-products, such as pieces of wood, and waste products, such as saw dust, to maximise revenues. Another example could be any business that refers their clientele to insurance companies, at a commission. Many opportunities to augment revenues exist within any given current client base.
Firstly, if expenses on an income statement, constitute more than two thirds of all sources of revenue, the business is bound to encounter difficulties. Scrutinize the income statement carefully, to verify whether expenses exceed more than two thirds. More elaboration on that later. The salary and wage bill, (including the owner managers salary) should never exceed more than one third of revenues. Whilst it is the highest of all expenses in most cases, maintain it at this level. Two thirds of revenue comprises expenses, one third comprises salaries and wages, (included in expenses)and the other one third should make up all other sundry expenses, such as rent, telephone etc. So effectively, provision has been made for a profit of one third.
One third may sound like too high a profit, when most small businesses barely attain 5 to 10%(of revenues) or run at losses. True, but this article attempts to give a framework. Another reason, is the contentious accounting “profit" model, which does not always translate into positive cashflow. Working capital difficulties, such as slow moving inventories and debtors inflate profits, but reduces cashflow. Providing for sufficient profits before it is realized, buffers the business against the knock-on effect of expenses.
The profit component will not be achieved, unless it is provided for, from the outset. On the cashflow forecast, a provision is made for “reserves" at 33,3% of expected revenues. The reserve is treated as a cash outflow and invested with a bank. When a final income statement is drafted a profitable position will transpire, at financial year-end that is more realistic.
It appears difficult at first, but will exert pressure on the owner to spend less, and be creative with his revenue. It also enables the business to use the income statement in a practical manner for profit and cashflow building.
Accounting and finance related queries can be addressed, on our website.
Feel free to visit our site by clicking on the url below.