By The Numbers: Understanding Income Statements

The most popular of all financial reports, the income statement, is one of two documents you should be receiving on a periodic basis – the other is the balance sheet. Some of us receive reports like these as often as monthly – and what do we do with them? Unless I miss my guess, we say thank you, slink off to the security of our office and stare at the reports in hopes that some flash of brilliance will leap off of the pages and inspire us as to what the documents mean. That’s a tragedy because, if you take the time to learn their messages, these reports can be two of your most valuable management tools.

Both documents provide a reader with critical information about the financial operations of the company. For example, the balance sheet, which is a company’s life-to-date scorecard, shows how liquid a company is and how effectively it uses its leveraging power. On the other hand, the income statement, a scorecard for a specific period of time, describes how much business a company performs in a given period and if it makes a profit on that work.

Among its many points of interest, the balance sheet shows how successful the company has been since its inception (retained earnings), how old its equipment is (fixed asset newness), how leveraged its assets are (debt-to-assets ratio), how much money it is able to borrow (debt-to-equity ratio), how effectively it manages its inventory (inventory turnover), how quickly it collects its money from customers (age of accounts receivable) and how stable its credit relations are with its vendors (age of accounts payable).

Were this an article on issues of cash flow, leverage or a company’s market value, we would spend a great deal of time understanding the various intricacies of the balance sheet. However, we will direct all of our attention to the cost structure of the company and how it sets up by each type of work it performs. For this information, we need to turn to the income statement.

ALL SET UP. The income statement is structured to tell us, among other things, how much revenue we have generated by type of work, what the raw cost is of what we were selling, what the support cost is of what were selling and how much profit we made by selling it. We all agree that this is valuable information to have at our fingertips, particularly if our charge is to run our businesses as efficiently as possible. Nevertheless, it is amazing how few companies have this data because they never appreciated how useful the data could be in the management of their business and because whoever set up their system didn’t do so in such a fashion that the information could be generated in an easy-to-read format.

Reading an income statement is fairly straightforward, given that we follow two very important criteria:

1. The income statement format must be complementary to how we do business.
2. The income statement must be broken into profit centers so that each type of business may be analyzed on its own merits.

The income statement describes the financial results of a particular period of time, i.e., 12 months or less. This is contrary to the balance sheet, which is a financial document describing the cumulative results of a company’s operations since its inception.

Why a 12-month cycle? You can thank Uncle Sam for that. In the early 1900s, Congress found that it could not live on hot air alone, so it passed into law what is now lovingly referred to as the federal income tax. The law’s passage formalized our government’s authority to tax businesses and individuals. The calendar year was adopted as the basic tax period – probably because it coincided with the natural cycle of our then agrarian economy.

Many companies have found that producing income statements on a more frequent basis than annually can be a real benefit to managers and owners, particularly if the data provided is processed in an accurate and timely manner. Probably the most popular timing for producing an income statement is monthly. The rationale is that a monthly cycle is best to measure the seasonal swings that are so typical in the green industry. Sometimes seasonality can be so servere that to produce a scorecard any less often would be tantamount to flying blind.

For the purposes of this article, we’ll refer to the fictional company Green Industry Inc., a multi-divisional company doing $1 million of business in exterior installation, exterior maintenance, interior maintenance and retail combined.

A quick read of the income statement summary for the exterior landscape division tells us that it performed $450,000 worth of work. This means that the division installed work that has a value of $450,000. Be careful not to confuse the value of work performed with how much work was sold, billed or collected during the period.

An equally quick glance to the bottom line reveals that the division generated $43,455 in net profits. This means that, against the $450,000 of work in place, the division spent a total of $406,545 in expenses to produce it, leaving a difference of $43,455. This difference is called net profit productive. The percentage to the right of net profit is its relationship to earned revenue – 9.66 percent – meaning that, on average, out of every dollar of revenue produced by the division, it was able to earn nearly 10 cents in profit.

Here is probably where many contractors will conclude the analysis process. They look at the top line, then look at the bottom line – ‘Great, we made money. Next issue.’

Sound familiar? It’s a pity to use this approach because the report provides a great deal of practical information to be used in daily management, if you can train your mind to look for it. Following are a series of footnotes to an income statement that should enlighten you to a few pieces of knowledge it can provide.

EARNED REVENUE. This is the value of work in place. In a construction operation, this number is a product of the percentage of completion method of accounting. An accountant will say that percentage of completion earned revenue is the total of our billings for the period, plus the value of the work we have installed and not yet billed, less the billings we have sent clients for work we have not yet performed. Whew! In layman’s terms, the way to understand earned revenue is to imagine if time were stopped on a certain day and we were challenged to measure exactly what had been installed on all of our jobs and bill that amount – what would the value of that invoice be?

DIRECT COSTS. This is a category of expenses representing the raw cost of what we sold to our customers. Direct costs tend to be unique in that they are easily identifiable with work we have done or products we have sold. In a contracting environment, direct costs resemble job estimates. That is, the elements of direct costs – plant material, hard material, direct labor, labor burden and subcontract costs – are those that are normally taken off by our estimator, costed and marked up for overhead and profit. No overhead or cost not easily identifiable to the job is included in direct costs. Rather, those expenses can be found in their own accounts in the overhead section on the income statement.

GROSS MARGIN. This is a term referring to the amount of money remaining from earned revenue once the out-of-pocket costs to provide the work are expensed. Gross margin can be found two ways: earned revenue minus direct costs equals gross margin or total overhead plus net profit equals gross margin. In the case of the landscape division, the remaining margin is $212,305 from an earned revenue of $450,000, once the specific costs (labor, material, subcontracts, etc.) to perform the work are expensed. The gross margin generated from our work is then used to pay for the overhead expenses of the division. Any money remaining from the gross margin once overhead is paid is profit – in this case, that is $43,455.

OVERHEAD EXPENSES. These are the costs spent in support of the sale. Many of them can be specifically identified with the job being installed or the product being sold, but typically are not, due to the difficulty of being able to estimate and track them uniformly. Therefore, these costs are placed in their own accounts in overhead and are applied to the direct cost of what we sell through our markup procedures.

Overhead expenses are commonly divided into three areas: indirect expenses, equipment expenses and administrative expenses. The rationale behind these breakdowns is to generate as much meaning as possible from the overhead listings for the division.

The number of subcategories is purely a matter of choice. We opted for three subcategories but could have just as easily had five or six or two or none. In your company, have as many as you wish, so long as the detail you generate does not detract from the readability of your statement.

In our example, total overhead expense as a percentage of earned revenue is 37.52 percent. This means that out of every dollar of sales, I can expect to spend an average of 37.52 cents in overhead. So here’s a question: If I were pricing a job, I would mark up the job by 37.52 percent to recover my overhead, right? Wrong – this percentage has absolutely nothing to do with pricing. It simply means that, on average, we as a division spend 37.52 cents of every dollar we sell to support the activity of what we are selling.

DISCLAIMER: The specific figures used in the above examples were developed for these examples. Each companies’ specific dollar values will vary based on their businesses.

Portions of the above article were excerpted from Pricing for the Green Industry, by Frank Ross. The book is available from the Associated Landscape Contractors of America at 800/395-2522.