Study: Analyzing a Common-Size, Multi-Step Income Statement

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Analyzing a Common-Size, Multi-Step Income Statement
- Slides 1-9 Links to an external site.

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Slides 1-2 (0m:48s) Links to an external site.Welcome to Introduction to Accounting Preparing for a User's Perspective
Analyzing a Common-Size, Multi-Step Income Statement

Review of Multi-Step Income Statement
The Candy Store Co. Multi-Step Income Statement provided below is from the last topic. In it, its revenues and expenses were classified based on how closely each item related to delivering goods and services to customers. The more closely tied they are to delivering goods and services to customers, the more likely they will be classified as part of Gross Margin Links to an external site., or Operating Income Links to an external site.. The less closely the items relate to delivering goods and services to customers, the more likely it is that they will be classified as "Other" Revenues and Expenses.

Sales Revenues represent sales of goods and services to customers so they are classified as part of Gross Margin.

Slide 3 (1m:25s) Links to an external site.

Cost of Goods Sold Links to an external site. (COGS) reflect the costs that the company incurred to
purchase, or manufacture the products that were sold to customers so they
are classified with Sales Revenue as part of Gross Margin
(i.e. Sales Revenue - COGS = Gross Margin). Gross Margin is also known
as Gross Profit Links to an external site..

Next the expenses that are used to support the company's process and
operations of selling goods and services to customers, such as Salaries
and Wages, Rent, Utilities, Advertising, Insurance, Postage, etc. are
classified as Operating Expenses and are deducted from Gross Margin
to arrive at Operating Income. Operating Income is the result of a company's
core operations. It is the company's main business which the company
hopes to improve upon in the future.

Revenues and expenses that are not closely tied to selling goods and
services to customers, or supporting the related operations, are called
"Other Revenues and Expenses". Examples of Other Revenues would be
Rent Revenue and Interest Revenue. Examples of Other Expenses would
be Interest Expense. Later we will learn about Gains and Losses on the
Sale of Long-Term Assets that will also be classified in the Other category.

After adding Other Revenues and deducting Other Expenses we arrive at
Income Before Taxes. Income taxes are then deducted to arrive at Net Income.

Slide 4 (1m:47s) Links to an external site.

Common-Size Income Statement
Although a Multi-Step Income Statement is helpful to users as is, it becomes even more helpful when the amounts on the Income Statement are all computed as a % of Sales Revenue to "Common-Size" them.

Let's take a minute to see what this Common-Size Income Statement Links to an external site. can reveal and how analysts might use it.

First off, the percentages in the far right-hand column were all computed
by taking the noted account balance and dividing it by the
Sales Revenue amount.

The COGS % is 30% indicating that its COGS uses up 30%, or $.30,
of every $1 of Sales Revenue computed as follows:
(i.e. COGS $30 / Sales Revenue $100 = 30%). This also means that 70%
of each $1 of Sales Revenue is left over as Gross Margin
(i.e. Gross Margin $70 / Sales Revenue $100) which 70% is actually
Candy Store's Gross Margin Ratio Links to an external site..

In order to gain greater insight into this company, an analyst would want to
compare Candy Store's 70% Gross Margin Ratio in the current year to
Candy Store's Gross Margin Ratio from its prior years to see whether it is on
a positive or negative trend. To make such a comparison, we would need
Candy Store's prior year Income Statement figures. When a single Income
Statement includes amounts for more than one accounting period, it is
called a Comparative Income Statement.

We will discuss how to use Comparative Income Statements in more detail
the next topic.

Slides 5-6 (0m:31s) Links to an external site.
In addition to comparing Candy Store's revenues and expenses to itself in the prior year, analysts will also want to compare Candy Store's current year numbers to those of its competitors.

Let's just look at one of Candy Store's %'s in detail such as its Wages Expense of 20% of Sales Revenue. An analyst would not only want to compare this percentage to Candy Store's % from prior years, which would have been about 18.75%, but also to Candy Store's competitors in the current year and strive to find out what may have caused its % to be higher, or lower, or even the same.

Slide 7 (1m:35s) Links to an external site.

For example, what do you think some logical explanations could be if the average Wages Expense % for other companies in the same industry was only 10% of Sales Revenue and what would you as management do about it?

Remember the formula is Wages Expense / Sales Revenue. Here are some plausible explanations for the difference:

1) The Candy Store's hourly pay rate for non-manufacturing workers may be higher than that of its competitors for the same, or lower, quality of worker.

Management might consider reviewing its salary and wages policies to ensure they are appropriate for each worker classification.

2) The Candy Store might be hiring more qualified workers and thus is paying them a higher hourly wage.

Management might want to verify that the skills of the higher paid workers are being fully utilized to justify the additional cost.

3) The Candy Store's hourly workers might be incredibly inefficient and work twice as many hours to complete the same tasks as its competitors.

Management might want to look into improving its worker training or its worker motivation strategies to increase efficiency and output.

4) The Candy Store's competitors may be generating more Sales Revenue by charging higher prices and thereby reducing the Wages Expense as a percentage of Sales Revenue.

Management might want to see if it can raise unit sales prices or increase sales volumes without significantly increasing its Wages Expense.

Clearly there are many other possible explanations for Candy Store's higher than average Wages Expense % which we don't have time to dig into here.

Slides 8-9 (0m:43s) Links to an external site.
I do hope you get the point that a Common-Size, Multi-Step Income Statement can be very effective in identifying unusually positive and negative relationships of expenses to revenues as compared to the company in the past or as compared to its competitors now. Once areas of concern have been identified and the causes have been understood, management and other users, can use what they learn to make plans for improvement. Sometimes management will realize that the best plan for the future will be to not fix what isn't broken.

Hopefully this topic on analyzing a Common-Size, Multi-Step Income Statement made sense to you. I wish you all the best on the quiz.