The most important elements of informative financial statements are 1) a well-defined Chart of Accounts and 2) an insightful classification (positioning) of totals in the financial statements.
Let’s take a look at how these elements are applied to a great Income Statement.
Sales: Each major product and/or service line should have its own account so sales for each are displayed on the face of the statement.
Direct Costs (COGS, COS): Direct costs are those that vary with the volume of sales and would not be incurred if sales did not occur. Examples are labor (and related payroll taxes), materials, subcontractors, royalty or licensing fees, and sales commissions. Codes for Direct Costs should correlate with the codes for product (or service) lines in Sales.
Gross Profit $ and Gross Margin %: With Sales and Direct Costs by product line, you can calculate the Gross Margin % by product line. This tells you at a glance which lines are profitable and which are drains. Also, accurate Gross Margin percentages can be used to make informed business decisions (see Issue #5—Using Breakeven for Decision Making).
Overhead (relatively fixed operating expenses): All operating expenses that are not classified as Direct Costs should be coded into clearly-defined Overhead accounts.
Income (Loss) From Operations: This number is Gross Profit minus Overhead. In investment and valuation circles, this number is called EBITDA—earnings before interest, taxes, depreciation, and amortization. It also represents Cash Flow from Operations. Businesses are most often valued at a multiple of EBITDA.
Other Income (Expenses): This is where all non-operating and non-cash items should be coded and classified, including interest income, interest expense, income taxes, depreciation, amortization, gain (loss) on sale of assets, and any other income/expense that is of a non-operating nature.
Net Income (Loss): Your bottom line is where all the chickens come home to roost. Are you healthy?
Financial reports are a lens through which you assess your present position and set your future course. You can refine that lens by taking your financial reports from good to great.
The Wisdom of Henry Hazlitt (1894-1993)
A hoodlum breaks the window of a baker’s shop. Onlookers decide that the vandalism has a bright side: a glazier will make $250 repairing the window.
Hazlitt disagrees. The glazier’s gain is money that the baker was planning to spend on a new suit. The onlookers did not take into account that a tailor lost a $250 sale and the baker lost a suit. No new employment was added—the scenario is a net loss.
– from Economics in One Lesson