Demystifying income statement metrics for small and mid-sized business owners

As a small or middle-market business owner, the ability to navigate your business’s financial statements plays a vital role in setting up your company for success. As you develop a better understanding of your business’s financials, you become better able to assess the strengths and weaknesses of your company and make informed decisions to steer it in the right direction. Of the standard financial statements, the income statement provides critical insight into a company’s performance over a specific period. Many performance metrics can be derived from this statement and identifying the most relevant ones for your organization can be a difficult task. In this blog, we will demystify some key income statement metrics that will be useful in assessing a company’s financial health.

Revenue

Revenue, also sometimes referred to as sales, represents the amount earned by a company through its normal operations over a specific period of time through the sale of goods or services to customers. For small businesses, revenue can be fundamentally explained by unit price times quantity sold. This simple formula calculates the total income generated from sales transactions in a period, which often serves as a leading indicator of financial health. Successful business owners keep close tabs on their revenue data and maintain dashboards to gain insights into metrics that may include:

1. Revenue by Product
2. Revenue by Customer and/or Channel
3. Revenue by Location

Analyzing revenue across multiple dimensions allows savvy business owners to prioritize the most profitable customer relationships, guide product development, and assess expansion opportunities as they grow their businesses.

Gross Margin

Gross Margin = Revenue – Cost of Goods Sold

Gross Margin % = Gross Margin/Revenue

Gross margin serves as a key profitability metric because it provides a snapshot of how much revenue remains after deducting costs from producing products or services. This metric enables owners to focus their analysis on the two key areas of the income statement: gross margin (which includes the cost of goods sold) and operating expenses. This segmentation is critical for effectively implementing cost-controlling initiatives; it also often provides insight as to the relative competitiveness of an industry or market.

Contribution Margin

Contribution Margin = Product Revenue – Product Variable Cost

Contribution Margin as a profitability metric is most useful when analyzing performance at a product or service level. This metric considers all variable costs associated with delivering a product, even if some of those costs are not components of the Cost of Goods Sold. What remains is the amount of profit (or loss) available to your company to cover fixed costs and contribute to the bottom line. Contribution Margin is most effectively used as a metric to evaluate the scalability of the business in conjunction with a cost-volume-profit analysis. With a good understanding of the contribution margin of a given product or service, business owners can understand how many units need to be sold to cover rent, break even, or achieve a certain level of net income or cash flow.

Net Income

Net Income = Revenue - Expenses

While revenue is an indicator of top-line performance, net income is an indicator of a company’s bottom line, or the overall profitability of the business. Net income is a simple and effective metric in determining how much revenue exceeds expenses, or vice versa. It serves as a useful indicator for stakeholders and owners in determining how well a company is performing as a whole. A common pitfall is that business owners may fixate on growing revenues and lose sight of how changes in operations are affecting the bottom line; as such, it is important to maintain a pulse on net income, especially during periods of growth.

Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA) and Management Adjusted EBITDA

EBITDA and Management Adjusted EBITDA are non-GAAP metrics used by business owners to assess company performance, often as a proxy for operating cash flow. These metrics can be valuable as they exclude one-time or non-operational and/or non-cash items from net income to show a more accurate view of the company’s operational efficiency.

EBITDA = Revenue – Expenses + Interest + Taxes + Depreciation + Amortization

EBITDA is an alternative measure of a company’s operating performance. Business owners and buyers like the metric because it allows one to assess the financial health of a company without considering the impacts of financing and accounting decisions. EBITDA is calculated by adding back interest, taxes, depreciation, and amortization expenses to net income. It serves as a beneficial tool in measuring a company’s operational efficiency and profitability related to normal operations.

Management Adjusted EBITDA = EBITDA + Discretionary Adjustments

Management Adjusted EBITDA and Pro Forma EBITDA are adjusted versions of EBITDA that take into account adjustments beyond interest, taxes, depreciation, and amortization. These metrics are often utilized by business owners and buyers to provide a better representation of the company’s operational performance by excluding expenses related to non-core activities, changes in accounting methodology, and one-time expenses. Management Adjusted EBITDA can be calculated by adding back to EBITDA non-cash, non-operating, and non-recurring items, to present a picture of profitability and cash flow that is more indicative of the future.

Which Should I Use?

The most successful business owners review multiple metrics on at least a monthly basis and understand how to analyze each effectively. Here’s a brief summary of each metric we discussed and how to use it:

1. Revenue – Measures income generated from normal operations. Tracking and reporting revenue in multiple dimensions (month over month, by customer group, by product line) allows owners to better understand trends and plan for the future.
2. Gross Margin – Measures the funds available after revenue-generating activities. Calculating gross margin every month and comparing to industry averages can be an effective method of comparing companies in terms of core profitability.
3. Contribution Margin – Measures funds available after subtracting all variable costs from revenues. Understanding the contribution margin is often key to modeling the scalability of a company.
4. Net Income – The bottom line that considers all revenues and all expenses. Owners should not neglect this simple metric as it will be key to understanding the path to future growth.
5. EBITDA and Management Adjusted EBITDA – Non-GAAP measures that support a specific operating level analysis of a business. These metrics are essential when evaluating the operating performance of a company, especially when preparing for a transaction event. 

Leveraging these metrics effectively enables you to identify areas for improvement, make informed business decisions, and drive sustainable growth. In addition to the profitability and performance indications provided by income statement-based measures, it is important to pair with key indicators from other financial statements and operational reports for a more complete view of your business’s health and trajectory.

At Siegfried Advisory, we help entrepreneurial organizations and business owners gain a better understanding of their key financial metrics that allow them to make more informed business decisions.  We seek to build long-term relationships that include thoughtful and meaningful discussions through Leadership Advisory, which helps business owners become better leaders of themselves and everyone around them. 

This article was contributed by Kevin O’Leary, Manager, Financial Advisory Services at Siegfried Advisory. You can contact Kevin directly at [email protected].