Use the income statement to refine value creation

The balance sheet shows a business' financial state at a point in time, while the income statement shows the operation of your business over a period of time.

The two financial documents most widely used are the balance sheet and the income statement. The balance sheet lists the assets, liabilities, and equity of an entity at whatever snapshot in time it’s written for. The income statement shows how the assets were used over a defined period.

When a manager wants to inspect the health of a business, he first reviews the balance sheet from today’s date. He looks for a number of things. Do we have sufficient current assets to cover our liabilities, or at least the most risky of them, or are our current assets too few to protect us if we needed to pay off our liabilities at once (also known as our liquidity)? Are we creating value for our owners over the course of the business? Is our accounts receivable asset at a reasonable amount, or do we see a rise in late payments for our services that could disrupt business?

When a manager wants to make the value-creation of the business more efficient, he reviews the income statement. What is the profit margin? Where are our highest net cost-of-sale expenses? How does our value-generating activity this period compare with the last? Is it less, or more than last period? Paired with the balance sheet, he might even ask, are all my assets generating equal value, or should I invest more in one asset over others?

A manager makes myriad business decisions. A startup manager may decide which market to explore next, or what action to take from the latest feedback on his minimum viable product. A mid-size business manager may decide how to expand his business into a new market segment or where to make his value-creation more efficient. A large business manager may choose which nation to open his next business arm, or which product line to expand for maximum profitability. While there are multiple factors that help a manager make these decisions wisely, accounting is always one of them.

The next market to explore is decided in part by the predicted profit margin. If the expenses outweigh the income, it’s not worthwhile to pursue that market. Another manager chooses to increase income by learning that a new market is willing to pay 10% more for his product than he initially thought. Yet another defends his decision to open in France instead of Italy by the advice of tax accountants from both countries. The accounting numbers matter in almost every business case a manager faces, and these numbers come to him primarily in the balance sheet and income statement.

It would be fascinating to compare personal balance sheets with my coworkers, or to review the balance sheets of the companies whose services I use. The Netflix balance sheet would be interesting to see what their measurable valuables are, as would the Amazon income statement. Why not look them up?

According to Bloomberg, Amazon’s assets have grown at a considerable rate, perhaps 70 billion in 2015 to 163 billion in 2018. The ratio of assets to liabilities has grown, which indicates Amazon has developed sizable equity for its owners since 2015. Amazon’s income over the same period rises sharply also, but the profit margin sits at 4.33%.

By comparison, Netflix has also grown tremendously since 2015, but a greater percentage of its assets are obligated to creditors; about 10% more. Looking at the income statement; however, shows Netflix achieving a higher profit margin of $7.67.

Of course, these are companies in different markets and at vastly different scales, but this shows how useful the balance sheet and income statement can be, even for an outsider who gets little detail.

References