If your profits are falling compared to revenue and assets, your financial statements may provide insight into what is happening and how to improve your performance.

Watch for red flags

As you sell more and invest in additional assets, profits should, in theory, increase by a proportionate amount. However, that is not always the case. Ratios to watch for a decline include:

• Gross profit [(revenue – cost of sales) / revenue]
• Net profit margin (net income / revenue)
• 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.

Identify possible causes

If these ratios are declining, it is important 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 a 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 often is 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 will 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 should not 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, which is simply 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 also can be revealing if you are trying to determine whether a profit margin decline arose from deteriorating industry conditions or weak management.

Find clues in your financials

Need help solving the mystery of your disappearing profits? Our auditors can use your financial statements to help compute financial statement ratios, identify problem areas, and find solutions to get your performance back on track.