The Basics of Financial Statement Analytics: The Income Statement
When a startup begins attaining outside loans, grants or investments, it will likely be required to submit periodic financial statements to its funders. Whether those financial statements are reviewed or audited by an independent accountant or prepared internally through an accounting software such as QuickBooks, it is important for management of the business to understand the fundamentals of the financial statements and how they will likely be used by external parties.
The following is a summary of some common calculations that financial statement users perform when analyzing a business’ income statement.
The income statement presents the overall operating results of a business over a period of time, typically the most recent fiscal year or quarter. It reports the business’ total revenues, expenses, and other gains and losses during that period. Here is an example of what a simple income statement might look like for an operating business in the revenue-earning stage:
Startup and emerging businesses may not have revenues to report, in which case they would also not report any Cost of Sales or Provision for Income Tax. Even in these cases however, it is still critical that expenses are reported accurately and categorized appropriately.
When preparing an income statement, it is important to understand the following distinctions:
- Operating vs. non-operating activities:
- Operating activities include revenues from sales of the business’ major products or services, employee salaries and other payroll expenses, and other expenses that are essential to the running of the business. Operating expenses are subtracted from operating revenues in order to determine Income from Operations.
- Non-operating activities include other gains and losses that are either ancillary to running a business or unusual/incidental items that are not expected to be recurring. Examples include interest income or expense, unrealized gains or losses on investments, and gains or losses on sales of assets. These items are included in Other Income and Expenses.
- Cost of Sales vs. Operating Expenses:
- Cost of Sales, or Cost of Goods Sold, represents expenses that are directly related to sales activity. It is therefore expected to fluctuate along with sales. Cost of Sales is deducted from revenues to calculate Gross Profit. Many financial statement readers will then divide Gross Profit by the Revenues to determine Gross Margin, a common analytical calculation meant to determine the level of profit made by the business on each sale.
- Operating Expenses, as discussed above, consist of all other expenses that are essential to running the business. In other words, they are expected to be incurred regardless of the level of sales activity during the year. The most common examples may include general salary and consulting expenses, rent and utility expenses, and insurance expenses.
For a business that sells physical inventory, Cost of Sales will typically represent the acquisition cost of inventory that is sold during the year. Businesses whose revenues are derived from the performance of services may not have any Cost of Sales since their products are their people, and their salaries may not depend on revenues. For Software-as-a-Service (SaaS) businesses, Cost of Sales may include the hosting expenses related to its software product in addition to any payroll or consulting expenses directly related to customer support.
Income Statement Analytics
There are a number of common analytics used by financial statement readers that require income statement items to be classified appropriately to be useful. Basic examples include:
- EBITDA: Earnings before Interest, Taxes, Depreciation and Amortization. Many lenders and investors will consider a business’ EBITDA to gain a clearer picture of its true operating results by excluding certain non-operating or non-cash activities from the business’ net income. They may also tailor EBITDA further to exclude other revenues, expenses, gains or losses that are not considered to be true indicators of the business’ success.
- Debt Service Coverage Ratio: This ratio can be calculated in several different ways. One method is to divide net income by the total debt payments made by a business during the year. Some lenders and investors may choose to use EBITDA instead of net income as the numerator. This ratio measures the overall reliability of a business in relation to its debt; in other words, the ability of a business to continue paying debt off over time. Lenders will often look for a Debt Service Coverage ratio of at least 1.25.
Lenders may write these calculations into their loan agreements as financial covenants, requiring that the borrower maintain minimum values of each in order to stay in compliance with the loan. Management should be reviewing the business’ financials on a regular basis and looking at these same calculations so that they can make the necessary decisions for the overall financial well-being of the business.
