How to Read An Income Statement Like a CFO | Ep 119

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Financial Intelligence Toolkit 

Ever wished you could interpret your company's income statement like a seasoned CFO? Unlock the secrets of financial literacy in my latest episode, where I break down the income statement into its core elements—revenue, expenses, and profits. Just as fluency in a new language opens doors to a new culture, mastering financial statements empowers you to make informed decisions that drive business value. I'll guide you through effective categorization of income streams and explain why it's crucial for your financial health.

Take your financial acumen to the next level as we dive into key financial metrics, starting with the cost of goods sold (COGS) and its pivotal role in calculating gross profit. Learn how to differentiate between gross profit and net income, and why understanding these distinctions is essential for assessing your business’s viability. Drawing from my experience as a CFO in a fast-growing FinTech startup, I'll share insights on how improving gross profit can attract investment, even when facing initial losses. We’ll also explore how to track gross profit trends to ensure operational efficiency.

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Transcript

Understanding Income Statements for Business

Steve Coughran 0:00

Welcome to BYFIQ, where we talk about business financial literacy, explore strategies for profitability and unlock the power of finance so you can make more money in business. I hope you enjoy and subscribe. Isn't it interesting that two people can read the exact same book but interpret it in a completely different manner? Well, the same thing is true with an income statement. One person can gloss over the numbers, looking at revenue, expenses and ultimately profit, and say, hmm, wow, that's interesting, whereas another person can look at the financial statement the same financial statement and understand the story behind the numbers. Now, obviously, I want you to be the latter person, because that's when you become a value creator in business, when you can understand the story behind the numbers and then do something about it. All right. So in this episode, I'm going to walk you through how to read an income statement like a CFO. Now, if you've been following my podcast and you are wishing that you can see this visually, because that's how I am I'm a visual learner I have good news for you. On my YouTube channel, which you can find by looking up Steve Cochran, I've been dropping a bunch of videos in the realms of finance and strategy. In other words, I have videos where I'll walk you through how to read an income statement, balance sheet and statement of cash flows, and I combine a bunch of other topics together in order to show you how strategy and finance drive value in business. So be sure to check out my YouTube I'll provide the link down below in the show notes if you want to learn more and deepen your financial expertise Now.

Steve Coughran 1:37

Understanding the financial health of a business is crucial for making informed decisions and driving growth. Remember, financial statements are your report card. Can you imagine running a business without financial statements? Now, look, that was me when I was starting out in business. When I first created my landscape business, I had no idea it was going to turn into this multimillion dollar business. So I didn't invest in my financial literacy and therefore, here I was, running a multimillion dollar company and I couldn't even read financial statements. So imagine, my decision-making at the time probably wasn't the best and I probably left a ton of money on the table. But I don't want this to happen to you and that's why we're going to be talking about the income statement today.

Steve Coughran 2:17

Now, the income statement, aka the P and L, is one of the most, but not the most important financial document for this purpose. Now, remember, my favorite financial statement is the statement of cash flows. But the income statement is a great statement to get started with, to understand how the company is performing and whether or not the operating model is working. It provides a summary of a company's revenues, expenses and profits over a specific period. Now, while anyone can read an income statement, interpreting it like a CFO requires a deeper understanding and some insider tips.

Steve Coughran 2:56

My wife has really been getting into piano lately and I'll sit down with her and listen to her play and I'll glance over her shoulder and I'll look at the music book and on the piece of paper it just looks like a bunch of gobbledygook with all the notes. Like I can't read music. But she could read the notes and then she can find the corresponding key on the keyboard and make music out of it, and I think that is so powerful. And if you take that metaphor to business, the same thing is true with finance. That's why I am such a big advocate on financial literacy, because if you know how to read financial statements I'm not talking about read the numbers on the financial statements but if you could look at a line item, for example, gross profit, and you say look, it's been declining for the last three months. Here are the three things I could do to go reverse this trend. That's when you become super powerful and valuable in business. So let's go ahead and explore how to read an income statement like a CFO, and I'll share some secret hacks to gain valuable insights along the way. So make sure you stay with me until the end, because you're not going to make sure you stay with me until the end, because you're not going to make sure you stay with me until the end, because you're not going to want to miss what I have to share at the very end of this episode.

Steve Coughran 4:09

All right, so number one, let's talk about understanding the structure of the income statement. So, before diving into the details, it's essential to understand the basic structure of the income statement, which consists of three main sections. Number one is revenue statement, which consists of three main sections. Number one is revenue. This section includes all the income that is generated from the sale of goods or services. It could be broken down into different categories, such as sales revenue, service revenue or other revenue, just depending on your company. Now, a good rule of thumb is this I wouldn't split out revenue and I wouldn't start creating different divisions unless that division is creating 10% or more of your revenue or it is on a fast track to do so, because otherwise you're going to be breaking out your revenue streams and they're going to be pretty immaterial and they're just going to muck up your financial statements. So make sure that you follow that rule of thumb. That will help you to keep things really simple. So that's the very top of the income statement, also known as the top line. All right, if you want to sound cool.

Steve Coughran 5:14

The next section is cost of goods sold. These are all the costs associated with producing or delivering your products and services to the end user. All right, so such costs may include materials, direct labor, contractor costs If you use subcontractors, or 1099 contractors, and all other costs related to the production of your revenue. So that's cost of goods sold, also known as cost of revenue, cost associated with revenue, or sales. All right, that's what I'm talking. Or sales? All right, that's what I'm talking about here. All right, after you take revenue and you subtract out cost of goods sold, you end up with gross margin, also known as gross profit. Now, this is not the bottom line. This is not profit. At the end of the day, this is just your gross profit before you're covering your overhead. All right, so this is just your gross profit before you cover overhead, all right. So this is just your gross profit before you cover overhead, all right. So this will tell you whether or not your operating model is working. In other words, it will tell you can you price your products and services competitively or in a manner where your customers want to buy your products and services at scale to cover your production costs in the business? All right. So if you're not earning gross profit or if your gross profit is declining, that is a major indication that something may be wrong with your strategy or your operating model. That's why I like to look at gross margin and the trends over time.

Steve Coughran 6:40

Now, as the CFO of a startup, we were growing very quickly. We were in the space of FinTech and we raised a bunch of capital from very well-known institutional providers. Now, during this time, we were losing a bunch of money because we're a startup and we're scaling very quickly. We were spending a lot of money on sales and marketing, which is down in overhead, not up above the line, and therefore the bottom line, the bottom bottom line, which I'll get into here in a minute. We were losing a lot of money all right on paper, but our gross profit in other words, our revenue minus the cost to produce that revenue was increasing with scale and therefore I was able to tell a story as a CFO to investors that was positive and that gave them hope into the future and therefore they were willing to invest more money into the business because they saw as we grew and as we scaled up, our gross profit was increasing from 20% to 22 to 25, to 33 to 38 and so on and so forth, and so I was able to tell a story there. So that's why gross profit is so critical, because maybe when you're starting out, your overhead is high, like higher than necessary, because you need to hire a bunch of people, you're trying to build the infrastructure of your business, and therefore you may be losing money at first because your overhead or your cost structure is higher than your gross margin, and that's completely fine. If your gross profit isn't showing improvement, or if it's not showing sustainability and resilience, then therefore it may indicate that you have a bad business model, right? So that's what we have Revenue, cost of revenue, also known as cost of goods sold, or COGS for short.

Steve Coughran 8:22

You take revenue minus COGS. You end up with gross profit, also known as gross margin. But we're not done yet, because we have to account for operating expenses, also known as OPEX. This includes selling, general and administrative expenses, such as sales and marketing, general and administrative payroll, rent, professional fees, insurance and all other expenses related to running the business Not expenses related to producing your products and services, but cost related to operating the company. All right, so if you take gross margin, you subtract out operating expenses, you end up with operating income. Then you have to account for non-operating expenses, such as. Then you have to account for non-operating income and expenses also shown in other income or expense, and once you subtract these out, you end up with net income, right?

Steve Coughran 9:22

Net income, also known as the bottom line, is the profit or loss after all revenues and all expenses have been accounted for, and it's calculated as net income equals total revenues minus total expenses, right? So that's the structure of the income statement and it's really important to understand how that all flows. Like I said, go to my YouTube channel If you want to see videos on this, or if you want to deepen your knowledge. You could always go to byfiqcom, which is boosting your financial IQ. That's the website where you could join a program, and that's for people who are serious about being successful in business. All right, so those are two resources you could check out to deepen your knowledge on how financial statements work. Okay, so now we understand the structure of the income statement, let's talk about focusing on key metrics. Now.

Steve Coughran 10:17

As a CFO, I pay close attention to certain key metrics on the income statement that provide insights into the company's performance. Now here are just a few. There are tons of metrics that I like to track in companies, and sometimes these metrics are specific to a certain company or industry, but here are just some common ones. Number one is gross profit margin. This metric shows the percentage of revenue that exceeds cost of goods sold, but here are just some common ones. Number one is gross profit margin. This metric shows the percentage of revenue that exceeds cost of goods sold. It indicates how efficiently a company is producing its goods. That's what I was just talking about up above. That's what I was just talking about a few minutes ago. So gross profit margin is revenue minus your cost of goods sold, divided by your revenue, and then you multiply that by a hundred percent. To put it in a percentage form Now, for most companies and I'm speaking super general because it depends on industry and a wide variety of factors but just as a very, very generic rule of thumb, I would say gross profit is usually between 30 and 50% for companies.

Steve Coughran 11:26

I know that's a wide range, but I just want to give you a number here so that can sink into your head. In other words, most companies, after they price their products and services and they earn revenue and they account for those costs to produce the revenue and they earn revenue and they account for those costs to produce the revenue, what's left over is around 30 to 50 cents on the dollar. All right, but then you have to cover operating expenses and then you get down to operating margin, which is next. This metric, operating margin, shows the percentage of revenue remaining after all operating expenses have been deducted from gross margin, so it reflects the company's operational efficiency. So operating margin is operating income divided by revenue times 100. And this percentage usually ranges between five and 15%. Once again, it depends on your industry, your size, your scale, all these other things. But as a rule of thumb, when I'm teaching this to companies and I'm setting standards, I say look your operating margin, your operating income, should be about 10% of your revenue.

Steve Coughran 12:36

Because think about it If you go and invest in the stock market over the last 50 years or so. Think about it If you go and invest in the stock market over the last 50 years or so, I think the stock market has returned around eight to 10%, depending on how you look at it and the timeframe in which you are covering. But let's just say it returns on average. We'll say 9%. Okay, if the stock market returns a 9% return. And if you're in business and you're only earning a 2% return, okay, that could be problematic. I mean, you're better off just putting your money in the stock market and avoiding all the headaches of running a business. Now I'm kind of being now I'm kind of being sarcastic here. I know it's a lot more nuanced than that, but my point is is that your business needs to be earning a return and if you're not earning around a 10% margin, you may be going through a whole lot of hassle for just a little bit of return. In other words, the juice may not be worth the squeeze.

Advanced Analysis of Income Statements

Steve Coughran 13:30

All right, let's move on to the last one, which is net profit margin. You'll notice I'm going down the line here. We started with gross profit margin, that's profit before your overhead. Then I went to operating margin, that's your profit before your non-recurring or non-operating expenses, and ultimately we're getting down to net profit margin, which shows the percentage of revenue that remains as profit after all expenses, including taxes and interest, have been deducted. It indicates the overall profitability of the company and essentially you just take net income divided by revenue times a hundred percent and that'll tell you your percentage.

Steve Coughran 14:09

Now, if you're wondering if your company has a competitive advantage, one way you could determine this is by looking at your bottom line, your net profit margin percentage, and then compare that to the industry average. And if you're earning a profit margin below industry average and if you're earning a net profit margin below industry average, well, guess what? You likely don't have a competitive advantage. Because if you had a good strategy and you have a competitive advantage based on your strategy, then you would be able to outperform your competitors and therefore have a competitive advantage based on your strategy. Then you would be able to outperform your competitors and therefore take a bigger piece of the profit pie home to you. Okay, so that's how I like to look at these financial metrics. Like I said, there are so many other financial metrics, but those are just three ways to look at profit from a gross profit, operating margin and net profit margin perspective. All right, now let's talk about number three, how I look at financial statements.

Steve Coughran 15:09

I like to analyze trends over time. So, as a CFO, I don't just look at a single income statement in isolation. I analyze trends over time. This helps me to identify patterns, detect potential problems and make informed forecasts. So here are some steps to analyze trends. Number one you can compare quarterly and annual results. You can look at income statements for different quarters and years to identify trends in revenue, expenses and profit. Are sales growing consistently? Trends in revenue, expenses and profit. Are sales growing consistently? Are expenses being managed effectively, and so on and so forth. So looking at trends period over period is super helpful. Now, also, in addition to this, I also like to calculate growth rates by determining growth rates for key metrics such as revenue, gross profit and net income, which I just explained. For key metrics such as revenue, gross profit and net income, which I just explained, this provides a clear picture of the company's growth trajectory.

Steve Coughran 16:06

And then, lastly, identifying seasonal patterns. So some businesses experience seasonal fluctuations in their performance and by recognizing these patterns, it can help in planning and decision-making. For example, when I was running my landscape company, I was always busy between April and October. That's where we generated the majority of our profits, and by understanding the trends and being able to forecast those trends, I was better equipped to make decisions in the off season, so I didn't run out of cash. So that's why it's important to understand seasonal patterns, and you could do this by putting your data into a trailing 12 month format. All right, so that's number three.

Steve Coughran 16:53

Number four dig deeper into revenue and expense categories. So a high level overview of the income statement is essential, but as a CFO, I also like to dig deeper into specific revenue and expense categories to uncover more insights. So here's some strategies. Number one is revenue breakdown. By analyzing revenue breakdown by product lines, geographical regions or customer segments, this helps me to identify which areas are driving growth and which need improvement. Also, with expense analysis, I like to scrutinize different expense categories to identify areas where costs can be controlled or reduced. I also like to look for unusual or unexpected expenses that may require further investigation. And, lastly, by monitoring expense ratios, such as selling general and administrative expenses as a percentage of revenue and cost of goods sold in like manner helps me to assess operational efficiency and determine where to focus my attention.

Steve Coughran 18:02

Now, when I'm analyzing expense categories, I like to look for areas where there's the greatest upside. That's really, really important because I don't want to get into the weeds of things. If certain categories aren't going to generate a big upside For example, occupancy expense, rent I may look at that and it may be high, but I may be locked into a lease so there may not be a lot that I could do in this area, whereas another category, like sales and marketing spend, there may be areas to cut or there may be better ways to allocate dollars in this section. All right, so that's how I like to look at revenue and expense categories and specifically try to identify areas with the biggest upside. Lastly, I like to use benchmarking for context. So, as a CFO, I've often used benchmarking to compare a company's performance against industry peers or competitors. This provides context and helps identify areas for improvements. This provides context and helps me to identify areas for improvement.

Steve Coughran 19:06

So here's some tips. First, industry averages by comparing your company's key metrics, such as gross profit margin, operating margin and net profit margin, which we've been talking about in this episode, helps you to understand how you're performing relative to an overall industry. Now, if you want to know how you stack up against your competition, though, if you could get data on your competitive set, in other words, the competitors who you're really competing against, this is going to be so much more beneficial. Now you may be wondering how do I do that, steve, because I. Now you may be wondering how do I do that, steve, because I'm a private company and this information is not available. That's why, when you work with companies or experts in the space consultants, accountants, whoever may be partners you're going to get so much more information because they work with a lot of other companies and if they're experts in the space, they'll be able to provide this data for you. So, when I'm working with companies, I know this information because I work with a ton of them and I see the financials of a lot of companies, and therefore this helps me to benchmark companies compared to their competitive set and, by using this proprietary data, it's super helpful when formulating strategy and determining where the business needs to focus to drive better performance. So benchmarking in your industry is really, really critical. Also by following best practices, in other words, identifying best practices from industry leaders and exploring how they could be implemented in your company, could be super beneficial to driving the bottom line. Now, if you're an entrepreneur or you're running a business and you want me to take a look at your financials and to give you some feedback, you can always connect with me at cultivarcom and I'm happy to help.

Steve Coughran 20:57

Now these are some secret hacks for advanced analysis. So to truly analyze an income statement like a CFO, consider these secret hacks for advanced insights. Number one common size analysis. When you convert each line on the income statement into a percentage of total revenue, it makes it easier to compare financial performance across periods or with other companies, regardless of size. In other words, just take each line item and divide it by revenue so you can express all the line items as a percentage of total revenue. Number two you can do variance analysis so you can compare actual financial results against your forecast, and then you can compare actual financial results against your forecast and then you can investigate significant variances to understand the reasons behind them and then take corrective actions if necessary. Also, you could do ratio analysis using financial ratios such as the current ratio, quick ratio, debt to equity ratio in conjunction with the income statement, will help you to gain a comprehensive view of a company's financial health.

Steve Coughran 22:05

Also, segment reporting If your company operates in multiple segments or business units, you can analyze income statements for each segment separately, which will then help you to identify the performance, which will then help you to identify the performance, which will then help you to identify performance drivers and challenges specific to each segment. And this granular view is super helpful because sometimes you'll find that one segment of the business is the segment that's earning all the money, and then you'll realize that other segments or divisions may be losing all your money. So that's why I like to carve things out on the financial statements and to dive into the granularity of them, sometimes. All right. And then the last piece also make sure you're considering non-GAAP measures. Gaap standing for Generally Accepted Accounting Principles such as EBITDA, earnings Before Interest Taxes, depreciation and amortization, for a clearer picture of operational performance. These measures can provide additional insights into the company's profitability and cashflow.

Steve Coughran 23:09

So, in conclusion, reading an income statement like a CFO involves more than just understanding the numbers. It requires a strategic approach focusing on key metrics, analyzing trends and digging deeper into revenue and expense categories. By using benchmarking and advanced analysis techniques, you can uncover valuable insights that drive better decision-making and, ultimately, business growth. So, whether you're a seasoned executive, a business owner or you're just an up and comer in your company and you want to learn how to make better financial decisions and how to interpret financial statements, these tips and hacks will help you to interpret the income statement with the expertise and precision of a CFO.

Steve Coughran 23:57

All right, that's a wrap. I hope you enjoy and share this episode, and also you can always leave feedback down below, especially if you're listening on Spotify. You can click on the link and you could drop some comments down below, and you could always connect with me at steve at byfiqcom, which stands for boosting your financial IQ, or you can find me on social media and you can hit me up there, happy to help in whatever way that I can. I hope you have a great week and until next episode, take care of yourself. Cheers.