Previously, I discussed the cash flow statement and how making observations from comparing cash flow statements over two years can raise questions about the financial position of a business and its cash flow.  In this article the focus is on reviewing the financial performance of a business by looking at the income statement.

A very efficient way of looking at financial performance involves comparing the figures from the income statement over several years using what is known as ‘vertical analysis’.

You can generate a report with prior year periods from your accounting software or even download the information into an excel spreadsheet.   You can put as much detail into this analysis as you have available or as you believe will be useful.  However, you would clearly benefit from having more detailed lists of the different expenses such as wages and salaries, rent, electricity, stationery, insurance, motor vehicles and so on.  Whatever further details are available for your analysis will enhance the understanding that you obtain from this process.  

What will vertical analysis tell you?  The information you obtain from vertical analysis is about any changes in the relative importance of revenue and expenses items over time.  The % column is calculated using the sales revenue figure as a constant benchmark of activity for each year, so sales revenue is always 100% and all the other figures are calculated as a percentage of sales revenue for that year.

The technique can be used in any sort of business whether it is private, public or not-for-profit.

‘Ratio analysis’ is another useful tool that may add to the findings of a vertical analysis as discussed below.

Ratios are a way of combining figures from the same and sometimes different statements to uncover relationships that we believe are meaningful.  In the income statement there are many ratios that we can ‘tease’ out of the data – the list will vary depending on the nature of your business.  Common ratios used by businesses to assess performance are:

Profit as a percentage of revenue – also know as ‘profitability’ or ‘profit margin’.  The ability to turn a dollar of sales into a profit is a key requirement in any business.  The ratio tells you how much profit you are making on every dollar of revenue.

Gross profit (GP) as a percentage of sales revenue – this ‘GP margin’ is mostly revenue for businesses that sell a physical product.  It represents the extent to which the business has ‘marked up’ the cost of its basic product in order to be able to make a profit on its sale.  When examining this ratio, it’s important to look for industry benchmarks – as some industries have higher mark-ups than others!

Expense ratio – every expense can be expressed as a percentage of the sales revenue figure, telling you if its relative size has become greater or smaller and leaving you to determine the implications of this change.

EBIT (earnings before interest and tax).  This is a measure of how well the business performs its core activity, but calculated before you extract from it the mandatory costs of having debt (i.e. interest) and paying tax.

The focus of these measurements is on the efficient use of resources to generate sales, as well as how well assets con be converted into cash.