unit 6 | income statement analysis & planning Flashcards
The ultimate goal of IS analysis
To Analyze Performance
Revenue Streams
Examine the cash inflows received from selling a product or service
- How a product/service is priced determines whether it is transactional or recurring
How are products/services priced?
How a product/service is priced determines whether it is transactional or recurring
Transactional Revenue Streams
A single transaction made without any further customer obligation
Business requires subsequent transactions from customers to keep earning revenue
Transactional Revenue Examples
Products ($ per t-shirt sold)
Usage ($per day snowboard rental)
Advertising ($ per click on IG)
Recurring Revenue Streams
Customer is locked into an obligation to pay a recurring amount based on some set frequency
Business do not require subsequent transactions from customers to keep earning revenue
Recurring Revenue Examples
Rental ($ per square foot/month)
Lease ($ per car leased/month)
Subscription ($ per user/month)
Revenue Drivers
The inputs that generate (drive) a company’s revenue, generally a function of volume or price
Difference between Revenue Drivers (price & volume)
Price is controllable, volume generally not (by-product of each price point)
Why is it important to understand Revenue Drivers
Important to understand the reason behind revenue changes (help management make meaningful & informed decisions)
Cost Structure
The combination of all the expenditures that an organization incurs to be able to earn revenue
- When assessing costs, type of business matters more than type of revenue stream
> COGS represent a significant amount of expenses for merchandise business
Similar Cost Structure Categories between Private & Public Companies
- Salaries/wages, Selling-General-&-Administrative (SG&A), depreciation
- Could also be presented by function
Cost Drivers
The inputs that generate (drive) a company’s costs, though they are not limited to two main drivers like revenue drivers are
- Depends on the type of cost that is being analyzed
Foundation Types of Financial Analysis and who uses them?
- Horizontal & vertical
- For management use only (internal)
> Public companies may choose to include some analysis in external reports (only critical information deemed useful to shareholders)
Horizontal (Trend) Analysis
Analyzing variances in line items over a span of time/across periods
- Can be very detailed (every J/E) or very high level (analyzing only FS line items)
- 3 common horizons: monthly, quarterly, & year-over-year (YoY) analysis
- Compared to previous actual results & budget
Important things to note in Horizontal (Trend) Analysis
- Pay attention to the analysis thresholds
- Ie. dollar & percentage variances - Determine whether the variance is expected
- Eg. COGS should be a certain % of revenue - Try to get 80%+ “coverage” of the variance
- Eg. if the variance is $10k, try to get an explanation for $8k+ of that variance - Quantify & explain WHY?
- Eg. $5.2M increase in sales of formal dresses due to corporate formal events in December
IS Profitability Metrics is used for what?
To assess performance
Gross Margin (Gross Profit Percentage) - Formula
Gross Margin = Gross Profit / Total Revenue
How is Gross Margin (Gross Profit Percentage) used?
Compared with prior periods or with competitors
Reconsider relationship or negotiate better prices w/ suppliers if ratio is lower than competitor
Operating Margin (EBIT Margin) - Formula
Operating Margin = Operating Income / Total Revenue
What is Operating Margin (EBIT Margin) used for?
The percentage of total revenue left over after all operating expenses have been paid
- Strong OM indicates company operations are effective at driving growth
> Doesn’t necessarily need external financing to be successful in the foreseeable future
- Useful when compared with competitors or industry averages
Benchmarking
The analytical process of comparing a company’s metrics to the rest of the industry or competitors
Net Profit Margin (Return on Sales) - Formula
Net Profit Margin = Net Income / Total Revenue
How is Net Profit Margin (Return on Sales) used?
The percentage of total revenue that remains after all costs are paid
- Can be interpreted as how many cents of profit the business generates for each dollar of sales made
- Useful across time or when used in benchmarking
When does Net Profit Margin play a key role?
Plays key role when obtaining financing
Potential Lenders → whether company is capable of of repaying debt obligations
Equity Investors → compare with other companies to determine most attractive investment option
Company valuations → pricing initial public offerings
Vertical Analysis
Compares a journal account, grouping, or FS line item to a base of 100%
- Typically, total assets are used as the base for BS accounts & line items, while total revenue is used as the base for IS accounts & line items
- Needs comparative figures to be meaningful
Important things to note in Vertical Analysis
- Pay attention to the analysis thresholds
- Ie. percentage variances - Determine whether the variance is expected
- Eg. if revenue mix changes, COGS mix should too - Coverage is not relevant the way it is in horizontal analysis
- Eg. focus on relationships between line items - Less focus on quantification, more focus on WHY?
- Eg. Salaries as a % of total revenue decreased because increase in revenue more than offset increase in salaries expense from extra staff hired in Dec
Budget Data allows company to analyze what 2 very important things?
- Whether their expectations of future performance are reasonable
- Whether (and why) they performed, or didn’t perform, as expected
Budget
An estimate of a company’s financial results & set internal financial targets for the next fiscal year
- Does not change (remain static)
- Expectations based on past experiences, plus
- Goals & targets for the future
> Used to inform internal stakeholders at a high level (to communicate financial targets)
What should be done with Budgeting targets?
Targets should be clearly communicated internally to ensure all employees understand where the company is heading in the next fiscal year, targets they are expected to meet, & how they can contribute
Strategic Planning
A corporate team responsible for analytical functions → financial analysis, budgeting, & forecasting
The Budgeting Process
Highly collaborative (& somewhat negotiated)
- Underlying motivation to dampen expectations so business leaders can achieve targets & be rewarded with bonuses at the end of the year for meeting or exceeding targets
- Executive mg’t (C-Suites) set expectations & targets, but not set in stone (unless top-down budget)
- After initial budgeting → reviews, modifications, & revisions until SM is satisfied
> BOD approves budget (END) → communicated to shareholders & market
Top-Down Budgets
Driven by executive management, with little to no input from the lower organizational levels
Bottom-Up Budgets
Driven by lower-level staff and management, with little to no guidance from senior management
Hybrid Budgeting
- Combination of the top-down and bottom-up budgeting approach
- Senior management provides targets like guidelines, while lower-level staff and management work to produce realistic expectations based on those guidelines
- Most efficient
Stretch Targets
Financial objectives that are meant to be challenging to attain
Important things to note about Budgets
- Do not obsess over precision
- Start with established expectations & known business patterns
- “Historically, Volume dips in Jan” - Expectations with be established in consultation with other departments
- Marketing budget discussed with Marketing VP - Not everything will change
- If no assets are expected to be disposed or purchased → no change - Some line items fluctuate significantly, pick a reasonable estimate
- Estimate based on an average, or high/low if there is an indicator
