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How To Avoid Disappointing Earnings At The End of The Year

Our parents told us not to compare ourselves to others. But in business, comparisons are useful.

Here are some useful comparisons to identify critical trends over time in the P&L:

  1. Current year to date vs. prior year to date (a/k/a year over year or YOY)

  2. Current month vs. prior months

  3. Trailing twelve months (TTM) vs. prior trailing twelve months

It's also useful to compare your P&L versus your industry average.

Here’s a YOY comparison of an income statement. The change in raw data is in blue and the percentage change in dollars YOY is in green.

Sales increased $8M over 2011 sales, a very impressive 67% growth rate (8M/12M).

Cost of Sales represented 60% of Sales in 2012 versus 55% in 2011, an unfortunate trend which is heading in the wrong direction. It’s not a good sign when Cost of Sales advance at a faster rate than Sales. In this case, Cost of Sales grew 82% while Sales grew 67%.

As a result, Gross Margin declined by 5 percentage points, from 45% to 40%. That 5% on $20M of sales would have generated $1M in additional Gross Profit and Net Income.

It’s nice that Gross Profit increased 48% YOY but not so nice in comparison to a 67% increase in YOY Sales. A commensurate 67% increase in Gross Profit, or $3.6M would have been better than the $2.6M increase achieved.

It is good that Operating Expenses (Overhead) increased at a slower rate than Sales increased YOY. Operating Expenses (Overhead) increased $2.6M which was necessary to operate a growing company. That was an increase of 54% YOY which is slower than the 67% increase in Sales.

It indicates that fixed overhead like rent and office salaries are being leveraged to increase sales. Also, Overhead as a percentage of Sales YOY decreased 3% which is also good. The higher the Sales, the lower Overhead should be as a percentage of Sales.

The bad news is that despite an $8M increase in Sales, Net Income was the same YOY. This means that the company spun their wheels, increasing sales without adding to the bottom line. It took on more overhead and more risk to support its growing sales.

It used working capital and likely borrowed funds or leased more space to accommodate its growth. But without adequate gross profit to cover the increased overhead, it was all for naught.

Gross Margin was the culprit. Had it stayed the same 45% as it was in 2011 (meaning an additional 5% of sales), Gross Profit and Net Income would have been $1M higher in 2012.

Management must analyze Gross Margin by product (stock-keeping unit (SKU)) to identify which products are dragging the overall Gross Margin down. It must also compare YOY changes in the general ledger accounts that are grouped in Sales (such as Sales Discounts) and Cost of Sales (such as Freight) to see which YOY percentage increases in those items exceeded the YOY percentage increase in Sales.

I hope this three part series, What’s In Your Margin, emphatically demonstrated how important these three things are for you to do:

  1. Know how your income and expense accounts are grouped in Sales, Cost of Sales and Overhead on your income statement

  2. Know the percentage each P&L account and income statement row bears to Sales, especially your Gross Margin and Net Margin

  3. Analyze trends in each P&L account and income statement row (compare last month to prior 6 months and year-to-date total to prior year-to-date total)

  4. Know how your income statement percentages compare with your industry’s average.

Quick, what’s your Gross and Net Margins? Don’t know? It’s time to get started.

If you need some guidance, call me and I’ll guide you through it: 305-467-5909.

P.S. This is the third and last article in my three-part series on income statement analysis, What’s in YOUR Margin? To further your understanding on how to use your income statement to make more money, read What’s in YOUR Margin? - Part I. To find out how to tell if the products or services you’re selling are profitable or if you’re losing money on them, read What’s in YOUR Margin? - Part II. You can then take action on the troublemakers to increase your bottom line.

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