Mehanna CPAs & Advisors | 199a deduction

Red Flags in your Profit and Loss

Your Income Statement is a profitability report, it reflects your income minus expenses. But this financial report is more than just a reflection of profitability, if used properly, it can become a financial tool to understand your financial health and controlling your operating expenses.

In this article, we attempt to break down what is an income statement, how it can be used, and how you can spot red flags within it.

What is an Income Statement 

The concept is easy enough, it presents your revenue and expenses. It runs you through the details of how the revenue you earn translates to net income. By reviewing this statement every month, you get a sense of the efficiency of your operations and how you manage them. It helps spot under-performing sectors and compare their performance to competitors.

The Income Statement can help form your pricing strategy

Constructing a routinary review of your profit and loss will create more accurate data for your financial analysis. One way you can use this data is to establish your pricing strategy. 

To do this, you calculate your gross profit, by deducting revenue and direct expense. These direct expenses include any staff members and materials that go into delivering the product or services you sell.

From calculating your gross profit, you can then apply two methods, Bottom-up Pricing or Top-down Quoting.

To apply the Bottom-up Pricing, you start with material costs, add administrative expenses, such as salaries, and then add a mark-up. 

To calculate Top-down Quoting, you determine the total price first. You can base it on the market price, how much your competitor’s prices are, or on the desired price increase. From that amount, you deduct the desired mark-up and the remainder will be the cost of your supplies and expenses. This method forces you to look for inexpensive suppliers and employees with competitive salary costs to fit the budget, so to speak.

Spot red flags

Data from the Income Statement are used not only for decision-making but also for avoiding certain decisions. You won’t have time to do keep an eye on each of your individual prices or jobs when your business starts growing. You will have to rely on the bigger picture which is your financial statements to spot any problems early on. For instance, if you see a pattern of decline in your gross margin, this is an early warning sign. It is often followed by an increase in revenue but a decline in bank balance and operating profit.

This happens because of an increase in expenses, due to business growth, which is faster than the increase of your revenue coming from the supposed increase in production. This means you are not pacing your business well. You could be growing your business too fast.

To counter this, you can lower your business expenses or raise your prices. You could look for a new supplier or you could cut your workforce which might not be fully utilized. A growing business should increase its personnel, but there should be a corresponding increase in revenue, otherwise, that’s a warning sign you should heed. 

Another red flag is an increase in your accounts receivable each month which means customers are paying you more slowly. Technically, you find the accounts Receivable in the Balance Sheet but this warning sign has a tell-tale sign in the profit and loss when you have a substantial increase in the revenue but a decrease in cash flow. 

Every financial statement is connected and you can’t help but take into consideration others for a holistic data-driven decision-making process. 

If you don’t have a regular salary for yourself reflected in your P/L, are you even sure your business is sustainable? 

The future

There are many ways to use the P/L to accommodate business analysis for growth or financial health. But above all else, the accuracy of your books should be of topmost importance. Without accurate data, you won’t recognize any warning signs from your financial statements and that could spell the end of your business. 

If you want to talk more about how financial metrics can be used to assess how your business is doing, you can reach out to us and we can construct a financial analysis for your specific needs. Remember, if you know where to look, you don’t have to scrutinize everything. 

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