If your profits are down, don’t panic.
Your financial statements can help you detect clues to solve the mystery of your disappearing profits.
Check for red flags
As you sell more and invest in additional assets, profits should, in theory, increase by a proportionate amount. However, that’s not always the case. Ratios to check for a decline include:
- Gross profit [(revenue – cost of sales) / revenue],
- Net profit margin (net income / revenue), and
- Return on assets (earnings before tax / total assets).
For all three profitability ratios, look at two key elements: changes between accounting periods and differences from industry averages.
Determine possible causes
If these ratios are declining, investigate to find the cause. If the whole industry is suffering, the decline is likely part of an external trend. If the industry is healthy yet your company’s margins are falling, perhaps management has lost its control of costs — or maybe vendor or receivables fraud is to blame. To find the root cause, it’s often helpful to study the main components of the income statement.
Revenue. If the top line (gross sales or revenue) has declined, your overall profit margin may fall because there is less revenue to spread fixed costs over. To determine if this trend is company-specific or industrywide, look at revenue trends of public companies in the same industry. Also, monitor trade publications, trade associations and relevant online sources for information.
Cost of goods sold. This category of expenses is a function of raw materials, labor and overhead elements. Direct materials and labor should be controllable and historically represent a consistent percentage of revenue.
Overhead is mostly fixed and shouldn’t significantly increase unless the company has made changes (for example, purchased new equipment, changed its depreciation policy, or relocated its production facility). Examine those elements to determine whether overhead is increasing or decreasing and how the ebb and flow applies to the gross margin (revenue minus cost of goods sold).
Selling and administrative costs. Check whether selling and administrative cost items increased significantly. This section of the income statement can also be revealing if you’re trying to determine whether a profit margin decline arose from deteriorating industry conditions or weak management.
Your financials tell all
Your financials are your best source of information to find the reason for declining profits. Need help solving the mystery of your disappearing profits? Our team of Ciuni & Panichi, Inc. auditors have been providing business advisory services for 45 years. We can help you identify problem areas and find solutions to get your performance back on track. Contact Brett Benjamin, Audit and Accounting Manager, at 216-831-7171 or by email here.
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