Last week’s webinar on reading income statements, hosted by The Executive Conversation, provided a great overview of one of the most common financial statements. You can watch an on-demand version of the audio and video without registering by clicking here.
As with all of the other information we cover on The Flip Side, the stated purpose of this webinar was to help sales people look at the income statement of a prospect or current customer and use the information to direct their sales strategy. Procurement can take a similar approach, using the highlighted portions of the statement to get a general sense of whether a supplier’s business is growing or not – and why.
If you consider attending the on-demand version of the webinar, you will notice that it is about 36 minutes long – so the guide is not a 10 minute over view of income statements, but how to review an income statement in 10 minutes: thereby reducing your ‘time to insight’ as they put it.
So why the income statement? While an income statement breaks down one year, a balance sheet covers everything bought/sold since inception. When you look at three years worth of income statements, you should be able to identify growth by looking at global operating segments or lines of business. Focus on identifying the growth location (e.g. operating unit) and percent of growth. If you have time, it is worth comparing the income statements to those of a key competitor and the industry as a whole.
The biggest mistake you can make is starting by looking at the bottom line (indicating profit or loss). Profits are nothing more than a function of what happened on every other line in that report. If you want a truer indication of performance, look at operating profit.
Instead, start with the top line (or revenue) over time. If sales/revenue are trending down, look at the cost/expense lines. According to Jim Melillo, The Executive Conversation’s co-founder and chairman and the speaker on this event, we are looking at another recession. Bad news continues to come from Europe. Every company wants to get revenues growing again. The easy money is in managing costs, but a longer-term turn needs to come from top line growth. As a procurement professional, it would be easy to dismiss these comments as being overly sales-focused, but the probability that our own executives feel the same way means we should give them due consideration.
Gross profit = sales – cost of goods sold (COGS).
It is critical to look at COGS as a percentage of sales - in hundredths of a percent. The terminology often used for this “basis points”: 3 basis points would be 0.003%.
Gross margin is gross profit expressed as a percent, so gross profit / revenue = gross margin
Executives want to hear about anything we can do to improve gross margin/gross profit. How do we improve gross margin/profit? By reducing material/input costs, getting a more optimal product mix, reducing services/labor cost, and getting to market faster (reducing time to market and therefore maximizing sales price v. manufacturing cost).
Look at changes in sales and marketing over time v. SG&A expenses over time. This answers the question of how much profit a company can make on a dollar of revenue. Any significant changes as a percentage of revenue over time are worth looking into further.
Don’t do business with a supplier that can’t tie the benefits of their solution to your financial statements. If you are looking to steer prospective suppliers in this direction (and you are a public company) it might be worth sending them a copy of your income statements and asking them for ideas on how to improve the current situation with their solution/proposal. The information they provide will be in numbers that are already tailor positioned to make the internal sell to finance.
If you are evaluating a private company, make a list of observations/questions based on what you know about a public company that matches the private one.
The key take-away from the event was to read the income statement down to the operating profit or loss line and then stop. The more ‘processed’ the numbers are, the more they have been manipulated by the company to tell a better story. For instance EBITDA (earnings before interest taxes, depreciation and amortization) was popularized by the cell phone industry because they had to keep subtracting things on their financial statements until they could find a ‘good’ number. Long term operating income is the truest measure of a company’s financial health.