Interpretation of Income Statements in Financial Management

Module Four: Session 3 Interpretation of financial statements Income Statement Module 4: Session 3 1 3/20/2025

Objectives of the session 1. To enable the participants appreciate the importance of income statements in financial and business management 2. To explain the income statement 3. To enable the participants interpret income statement. 4. To enable participants use income statements to make decisions Module 4: Session 3 2 3/20/2025

Understanding income statement Financial statement that measures a company's financial performance over a specific short term accounting period. Gives a summary of business revenues and expenses Shows the bottom line - profit or loss incurred over an accounting period, typically in a month, a quarter but not exceeding a year. Module 4: Session 3 3 3/20/2025

Uses of the Income Statement To show a firm s profitability To provide the basis for a variety of decisions; Taxation, dividends, investment and growth decisions. To help lenders to assess the business s ability to meet interest. To inform managers and investors how well the firm s pricing strategy has accomplished stated objectives. Module 4: Session 3 4 3/20/2025

Income statement content Revenue: The net value of a company's sales of goods and services to its customers. Cost of works: The cost of materials, labour and production overheads consumed to produce the works. Gross profit: Gross margin or the difference between revenue and cost of works. Other expenses: Selling, Management, administrative, financing and general expenses incurred to run the business Income before tax , Income tax, Income after tax. Module 4: Session 3 5 3/20/2025

Profitability ratios Gross profit margin Gross Profit/Net Sales = ____%. EBIT/Net Sales = _____%. Operating Profit Margin (EBIT) Net Profit Margin Net Income before tax/Net Sales = _____%. EBIT/Total Assets = _____%. Return on Assets Income after tax/ Equity = _____%. Return on Equity EBIT Earnings before interest and tax Module 4: Session 3 6 3/20/2025

Cost ratios Cost of works to revenue Cost of works/Revenue = ____%. Cost of material/ Revenue = _____%. Labour cost/Revenue= _____%. Material cost ratio Labour cost ratio Revenue/labour cost or labour hrs= _____. Labour productivity ratio Production overheads/Revenue = _____%. Production overheads ratio Interest/net sales= _____%. Interest ratio Interest cover EBIT/Interest Module 4: Session 3 7 3/20/2025

Profitability ratios in financial analysis Gross Profit Margin: looks at cost of works as a percentage of revenue. This ratio reflects the pricing policy of a business: Operating Profit Margin: measuresoperating efficiency, incorporating all of the expenses excluding financing costs as a percentage to revenue. Net Profit Margin: is a measure of overall operating efficiency, incorporating all of the expenses of production, administrative and financing of business activity as percentage of revenue. When all is done what is earned out of revenue generated. Module 4: Session 3 8 3/20/2025

Contd Return on assets is an important profitability ratio because it measures the efficiency with which the company is managing its investment in total assets and using them to generate profit. It is the ratio of earnings before interest and tax (EBIT) to total assets (equity plus debt). Return on Equity/Return on investment: It measures the return on the investment owners have put into the company. This is the ratio potential investors look at when deciding whether or not to invest in the company. Module 4: Session 3 9 3/20/2025

Using comparatives Financial ratio analysis is most useful if there is comparative data available. Comparison to different periods indicates the trend of performance Comparison to business plans or budgets indicates the extent of achievement Comparison to industry data benchmarks performance Module 4: Session 3 10 3/20/2025

Using income statement to make a decision Assess return on equity and evaluate the satisfaction levels of owners of the business. Inadequate returns may push them to change management or switch investment. Evaluate top-line sales trends. E.g. if your competitors are growing sales while you're staying flat or declining, there could be a marketing mix or management execution issue. Evaluate profit margin trends. If your margins are falling while theirs are not, your cost structure may be too high. Study materials, labour and overhead cost percentages to revenue, they will indicate the efficiency of your methods as well as your ability to control costs. Calculate times-interest-covered: This ratio indicates your ability to meet interest payments and capacity to borrow more. Module 4: Session 3 11 3/20/2025

Income Statement uses & limitations Provide Overview: An income statement provides potential investor with an overview of whether the business is likely to be a good investment. Measures performance to owners and management Offers a basis to provide for dividends: Most income statements include a statement of the business earnings per share. Point out weaknesses: Owners and management can find weaknesses in their business's pricing and cost structure. Gives insight into adequacy of capital structure. Limitations: Is only a short term measure of performance and stakeholders may not make decisions without looking at other statements such as the balance sheet and cash flow. Module 4: Session 3 12 3/20/2025

Group Activity 1. Identify and discuss major components that make up income statements. 2. Identify core profitability ratios and explain their uses to the business owner. 3. List the weaknesses of ratios in interpreting income statements. 4. Explain the benefits of preparing accurate and timely Income Statements to stakeholders (Shareholders, management and credit institutions) 5. Discuss the indicators by themselves, or taken together that could indicate from an income statement that the going concern may be brought into question. Module 4: Session 3 13 3/20/2025

END Q & A Module 4: Session 3 14 3/20/2025