Income statement analysis can be carried out using ratios based on information contained within the income statement. Understanding how to read a income statement and regular monitoring of the income statement ratios provides owners and management with a useful tool to help them manage their business more effectively.
By analyzing the income statement a business is able to see how it is performing relative to earlier accounting periods, and how its performance compares to other businesses in the industry.
Example of income statement Analysis
Consider the example income statement below.
| Revenue | 48,077 |
| Cost of sales | 37,288 |
| Gross margin | 10,789 |
| Research and development | 1,909 |
| Sales and marketing | 6,216 |
| General and administrative | 658 |
| Operating expenses | 8,783 |
| Depreciation | 1,000 |
| Operating income | 1,006 |
| Finance costs | 72 |
| Income before tax | 934 |
| Income tax expense | 291 |
| Net income | 643 |
Numerous ratios can be calculated using income statement information, however, we shall concentrate on four main ratio formulas which can be used to carry out income statement analysis.
The four financial ratios are:
- Gross margin ratio
- Operating margin ratio
- Net profit margin ratio
- Interest coverage ratio
Gross margin ratio
The gross margin ratio is the ratio of gross margin to the revenue of the business expressed as a percentage. More details on the calculation of the ratio can be found in our gross margin ratio tutorial.
From the information above, the income statement analysis shows:
Gross margin ratio = Gross margin / Revenue Gross margin ratio = 10,789 / 48,077 Gross margin ratio = 22.4%
The gross margin ratio is a very important indicator of profitability. The gross margin is the real income of the business, is whats left after the cost of sales has been deducted from the revenue.
In a well run business, the gross margin ratio should be stable and should not fluctuate from one accounting period to the next. In the above example the gross margin ratio is 22.4%, but will vary from industry to industry.
Operating margin ratio
The operating margin ratio, sometimes referred to as the return on sales, is the ratio of the operating income to the revenue of the business expressed as a percentage. More details on the calculation of the ratio can be found in our operating margin ratio tutorial.
From the information above, the income statement analysis shows:
Operating margin ratio = Operating income / Revenue Operating margin ratio = 1,006 / 48,077 Operating margin ratio = 2.1%
The operating margin ratio is an indicator of the ability of the business to manage its operating expenses efficiently to make a profit from its current operations. Because it is calculated using the operating margin which is before finance costs and taxation have been deducted, it is a useful ratio for comparing the operating efficiency of businesses before the effects of its financial structure and taxation system have been taken into account.
In a well run business the operating margin ratio should be increasing each period as management gets control over the operating expenses and makes efficiency savings.
In the above example the operating margin ratio is 2.1%, but will vary from industry to industry.
Net profit margin ratio
The net profit margin ratio is the ratio of the net income to the revenue of the business expressed as a percentage. More details on the calculation of the ratio can be found in our net profit margin ratio tutorial.
From the information above, the income statement analysis shows:
Net profit margin ratio = Net income / Revenue Net profit margin ratio = 643 / 48,077 Net profit margin ratio = 1.3%
The net profit margin ratio shows what percentage of the revenue is left after deducting all expenses of the business. The higher the net profit margin ratio the more profit the business earns on its revenue. In the above example the net profit margin ratio is 1.3%, but the value will vary from industry to industry.
Interest coverage ratio
The interest coverage ratio, sometimes referred to as the times interest earned ratio, is the ratio of the operating income to the finance costs (interest) of the business. More details on the calculation of the ratio can be found in our interest coverage ratio tutorial.
From the information above, the income statement analysis shows:
Interest coverage ratio = Operating income / Finance costs Interest coverage ratio = 1,006/ 72 Interest coverage ratio = 13.97
The interest coverage ratio is a measure of the ability of a business to make interest payments on its debt, as such it is a measure of the credit worthiness of the business.
In the above example the interest coverage ratio is 13.97 meaning that the operating income of the business could pay the finance costs 13.97 times.
Income Statement Analysis Over Time
By calculating income statement ratios at the end of each accounting period, it is possible to monitor changes in the business over time. For example, the following shows the income statements of the same business for two different financial periods.
| 2018 | 2017 | |
|---|---|---|
| Revenue | 48,077 | 34,204 |
| Cost of sales | 37,288 | 26,561 |
| Gross margin | 10,789 | 7,643 |
| Research and development | 1,909 | 1,182 |
| Sales and marketing | 6,216 | 3,851 |
| General and administrative | 658 | 470 |
| Operating expenses | 8,783 | 5,503 |
| Depreciation | 1,000 | 552 |
| Operating income | 1,006 | 1,588 |
| Finance costs | 72 | 91 |
| Income before tax | 934 | 1,497 |
| Income tax expense | 291 | 352 |
| Net income | 643 | 1,145 |
The income statements show that the business has grown between the two accounting period. As a direct comparison, it is difficult to establish any pattern or issues with the business. However, if income statement ratio calculations are carried out for the two periods the following income statement analysis comparison table can be produced.
| 2018 | 2017 | |
|---|---|---|
| Gross margin ratio | 22.4% | 22.3% |
| Operating margin ratio | 2.1% | 4.6% |
| Net profit margin ratio | 1.3% | 3.3% |
| Interest coverage ratio | 13.97 | 17.45 |
The business has grown over the two accounting periods and the absolute values of most line items are significantly higher. However, despite this growth, the business made more net income in 2017 than it did in the 2018.
Using the income statement analysis ratios we can see that the gross margins have remained stable at 22.4% and 22.3% as they should do in a well run business. However, the operating margin ratio has fallen from 4.6% to 2.1% indicating a lack of management efficiency in controlling the operating expenses of the business as it grows. The fall in the operating margin ratio of 2.5% of revenue offset by finance cost and tax savings, causes the net profit margin ratio to fall by 2% of revenue from 3.3% to 1.3%.
By continuing to carry out the income statement analysis each period, the business can monitor the changes in the ratios and make appropriate correcting changes at an early stage.
The financial statement analysis could equally well be used to compare the business with competitors or businesses in different industries. Alternatively, by using standard industry data, the business could be compared to industry averages to see whether it is performing above or below what is normal for the trade.
About the Author
Chartered accountant Michael Brown is the founder and CEO of Double Entry Bookkeeping. He has worked as an accountant and consultant for more than 25 years in all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a BSc from Loughborough University.