Put your income statement to good use

Put your income statement to good use

By midyear, most businesses that follow U.S. Generally Accepted Accounting Principles (GAAP) have issued their year-end financial statements. But how many have actually used them to improve their business operations in the future? Producing financial statements is more than a matter of compliance — owners and managers can use them to analyze performance and find ways to remedy inefficiencies and a[...] nomalies. How? Let’s start by looking at the income statement. Benchmarking performance Ratio analysis facilitates comparisons over time and against industry norms. Here are four ratios you can compute from income statement data: 1. Gross profit. This is profit after cost of goods sold divided by sales. This critical ratio indicates whether the company can operate profitably. It’s a good ratio to compare to industry statistics because it tends to be calculated on a consistent basis. 2. Net profit margin. This is calculated by dividing net income by sales and is the ultimate scorecard for management. If the margin is rising, the company must be doing something right. Often, this ratio is computed on a pretax basis to accommodate for differences in tax rates between pass-through entities and C corporations. 3. Return on assets. This is calculated by dividing net income by the company’s total assets. The return shows how efficiently management is using its assets. 4. Return on equity. This is calculated by dividing net profits by shareholders’ equity. The resulting figure tells how well the shareholders’ investment is performing compared to competing investment vehicles. For all four profitability ratios, look at two key elements: changes between accounting periods and differences from industry averages. Plugging profit drains What if your company’s profitability ratios have deteriorated compared to last year or industry norms? Rather than overreacting to a decline, it’s important to find the cause. If the whole industry is suffering, the decline is likely part of a macroeconomic trend. If the industry is healthy, yet a company’s margins are falling, management may need to take corrective measures, such as: Reining in costs, Investing in technology, and/or Looking for signs of fraud. For example, if an employee is colluding with a supplier in a kickback scam, direct materials costs may skyrocket, causing the company’s gross profit to fall. Playing detective For clues into what’s happening, study the main components of the income statement: gross sales, cost of sales, and selling and administrative costs. Determine if line items have fallen due to company-specific or industrywide trends by comparing them to public companies in the same industry. Also, monitor trade publications, trade associations and the Internet for information. Contact us to discuss possible causes and brainstorm ways to fix any problems. © 2017

Controls Assessment

The Securities and Exchange Commission (SEC) requires public companies to evaluate and report on internal controls over financial reporting using a recognized control framework. Private companies generally aren’t required to use a framework for the oversight of internal controls, unless they’re audited, but a strong system of checks and balances is essential for them as well.

A critical process

Reporting on internal controls is an ongoing process, not a one-time assessment, that’s affected by an entity’s board of directors or owners, management, and other personnel. It’s designed to provide reasonable assurance regarding the effectiveness and efficiency of operations, the reliability of financial reporting, compliance with applicable laws and regulations, and safeguarding of assets.

A strong system of internal controls helps a company achieve its strategic and financial goals, in addition to minimizing the risk of fraud. At the most basic level, auditors routinely monitor the following three control features. These serve as a system of checks and balances that help ensure management directives are carried out:

1. Physical restrictions. Employees should have access to only those assets necessary to perform their jobs. Locks and alarms are examples of ways to protect valuable tangible assets, including petty cash, inventory and equipment. But intangible assets — such as customer lists, lease agreements, patents and financial data — also require protection using passwords, access logs and appropriate legal paperwork.

2. Account reconciliation. Management should confirm and analyze account balances on a regular basis. For example, management should reconcile bank statements and count inventory regularly.

Interim financial reports, such as weekly operating scorecards and quarterly financial statements, also keep management informed. But reports are useful only if management finds time to analyze them and investigate anomalies. Supervisory review takes on many forms, including observation, test counts, inquiry and task replication.

3. Job descriptions. Another basic control is detailed job descriptions. Company policies also should call for job segregation, job duplication and mandatory vacations. For example, the person who receives customer payments should not also approve write-offs (job segregation). And two signatures should be required for checks above a prescribed dollar amount (job duplication).

Controls assessment

Is your company’s internal control system strong enough? Even if you’re not required to follow the SEC’s rules on assessing internal controls, a thorough system of checks and balances will help your company achieve its goals. Company insiders sometimes lack the experience or objectivity to assess internal controls. But our auditors have seen the best — and worst — internal control systems and can help evaluate whether your controls are effective.

© 2017