What is the first item you look at when you read your company’s income statement? I bet that you look for the net income results as soon as you receive the income statement report from your accountant. The net income is a very common profitability indicator because it represents the residual income that the company receives after all the expenses have been accounted for.
But when analyzing your company’s financial performance, on a monthly or yearly basis, following movements in your net income is not enough to evaluate its overall earning capacity. This is because the net income reported in your income statement includes income and expenses that are not part of your core operations.
It is possible for a company to report a positive net income despite losing heavily from its core business on a one-time gain on, say, a sale of a piece of property. If you were an investor looking to buy the company and presented with only net income comparisons, you might be deceived into thinking that the company has consistent earnings.
So what should you look for in the income statement other than the net income? You should consider the operating income as the better indicator of your company’s earning power. The operating income is the income that the company realizes from its core business before other items are accounted, as computed below:
Sales – Cost of Sales = Gross Profit – Operating Expenses = Operating Income
Using the operating income margin as an indicator—computed by simply dividing operating income by total sales—will allow you to measure management’s efficiency in running the business. The higher the margin, the more efficient—this means that operating expenses are consciously guarded as sales grow.
The operating income margin also helps you to compare your position against your competitors in the same industry. For example, if you are in the food business, you may compare your margins with the industry average of 25 percent.
Henry Ong, CMA, RFP, is president and COO of Business Sense Inc., a financial advisory and consulting firm that helps small and medium businesses. Business Sense is affiliated with the International Network of Certified Public Accountants. You may reach him at firstname.lastname@example.org or log on to http://www.businesssense.com.ph for more financial tips online.