unit 6 | income statement analysis & planning

Question 1

The ultimate goal of IS analysis

Answer 1

To Analyze Performance

Question 2

Revenue Streams

Answer 2

Examine the cash inflows received from selling a product or service
- How a product/service is priced determines whether it is transactional or recurring

Question 3

How are products/services priced?

Answer 3

How a product/service is priced determines whether it is transactional or recurring

Question 4

Transactional Revenue Streams

Answer 4

A single transaction made without any further customer obligation

Business requires subsequent transactions from customers to keep earning revenue

Question 5

Transactional Revenue Examples

Answer 5

Products ($ per t-shirt sold)
Usage ($per day snowboard rental)
Advertising ($ per click on IG)

Question 6

Recurring Revenue Streams

Answer 6

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

Question 7

Recurring Revenue Examples

Answer 7

Rental ($ per square foot/month)
Lease ($ per car leased/month)
Subscription ($ per user/month)

Question 8

Revenue Drivers

Answer 8

The inputs that generate (drive) a company’s revenue, generally a function of volume or price

Question 9

Difference between Revenue Drivers (price & volume)

Answer 9

Price is controllable, volume generally not (by-product of each price point)

Question 10

Why is it important to understand Revenue Drivers

Answer 10

Important to understand the reason behind revenue changes (help management make meaningful & informed decisions)

Question 11

Cost Structure

Answer 11

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

Question 12

Similar Cost Structure Categories between Private & Public Companies

Answer 12

• Salaries/wages, Selling-General-&-Administrative (SG&A), depreciation
• Could also be presented by function

Question 13

Cost Drivers

Answer 13

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

Question 14

Foundation Types of Financial Analysis and who uses them?

Answer 14

• 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)

Question 15

Horizontal (Trend) Analysis

Answer 15

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

Question 16

Important things to note in Horizontal (Trend) Analysis

Answer 16

1. Pay attention to the analysis thresholds
   - Ie. dollar & percentage variances
2. Determine whether the variance is expected
   - Eg. COGS should be a certain % of revenue
3. Try to get 80%+ “coverage” of the variance
   - Eg. if the variance is $10k, try to get an explanation for $8k+ of that variance
4. Quantify & explain WHY?
   - Eg. $5.2M increase in sales of formal dresses due to corporate formal events in December

Question 17

IS Profitability Metrics is used for what?

Answer 17

To assess performance

Question 18

Gross Margin (Gross Profit Percentage) - Formula

Answer 18

Gross Margin = Gross Profit / Total Revenue

Question 19

How is Gross Margin (Gross Profit Percentage) used?

Answer 19

Compared with prior periods or with competitors
Reconsider relationship or negotiate better prices w/ suppliers if ratio is lower than competitor

Question 20

Operating Margin (EBIT Margin) - Formula

Answer 20

Operating Margin = Operating Income / Total Revenue

Question 21

What is Operating Margin (EBIT Margin) used for?

Answer 21

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

Question 22

Benchmarking

Answer 22

The analytical process of comparing a company’s metrics to the rest of the industry or competitors

Question 23

Net Profit Margin (Return on Sales) - Formula

Answer 23

Net Profit Margin = Net Income / Total Revenue

Question 24

How is Net Profit Margin (Return on Sales) used?

Answer 24

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

Question 25

When does Net Profit Margin play a key role?

Answer 25

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

Question 26

Vertical Analysis

Answer 26

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

Question 27

Important things to note in Vertical Analysis

Answer 27

1. Pay attention to the analysis thresholds - Ie. percentage variances 2. Determine whether the variance is expected - Eg. if revenue mix changes, COGS mix should too 3. Coverage is not relevant the way it is in horizontal analysis - Eg. focus on relationships between line items 4. 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

Question 28

Budget Data allows company to analyze what 2 very important things?

Answer 28

1. Whether their expectations of future performance are reasonable 2. Whether (and why) they performed, or didn’t perform, as expected

Question 29

Budget

Answer 29

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)

Question 30

What should be done with Budgeting targets?

Answer 30

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

Question 31

Strategic Planning

Answer 31

A corporate team responsible for analytical functions → financial analysis, budgeting, & forecasting

Question 32

The Budgeting Process

Answer 32

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

Question 33

Top-Down Budgets

Answer 33

Driven by executive management, with little to no input from the lower organizational levels

Question 34

Bottom-Up Budgets

Answer 34

Driven by lower-level staff and management, with little to no guidance from senior management

Question 35

Hybrid Budgeting

Answer 35

- 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

Question 36

Stretch Targets

Answer 36

Financial objectives that are meant to be challenging to attain

Question 37

Important things to note about Budgets

Answer 37

1. Do not obsess over precision 2. Start with established expectations & known business patterns - “Historically, Volume dips in Jan” 3. Expectations with be established in consultation with other departments - Marketing budget discussed with Marketing VP 4. Not everything will change - If no assets are expected to be disposed or purchased → no change 5. Some line items fluctuate significantly, pick a reasonable estimate - Estimate based on an average, or high/low if there is an indicator