The income statement tries to indicate how well a business performed in the most recent accounting period. Assuming that such performance is accurately portrayed, can this information help predict the firm’s future performance? The answer depends largely on the firm’s economic environment.
Some businesses operate in very stable, predictable economic environments; others do not. Economic stability is primarily a function of the demand for a firm’s goods and services, the degree of competition, and the price stability of the goods and services the firm needs to provide its products and services.
Certain goods and services are more essential than others. For example, because people need food, shelter, and medicine, there will always be a fixed demand for these goods and services. Other goods and services are not as essential. Cosmetics, sports equipment, and leisure travel are examples of less essential goods and services. The overall demand for essential goods and services generally is more stable than the demand for less essential services. Demand for essential services is less likely to fluctuate with upturns and downturns in the economy than demand for less essential services.
In general, a business that supplies essential goods and services will have a more predictable revenue stream than a business that supplies less essential goods and services. Thus, the revenue or sales component of the income statement of a business providing essential goods and services is more useful in predicting future revenue or sales than the income statement of a business providing less essential goods and services.
The degree of competition a business faces is another key factor in the predictability of a firm’s earnings. As a rule, the more competitors there are in a particular market, the less control each competitor has over the selling price of its products or services. The less control a firm has over the prices it charges, the less predictable are its revenue and sales.
Finally, the stability of factors of production varies from business to business. A business that sells coffee or chocolate can be adversely affected by rising prices of coffee and cocoa beans. Generally, the supply and cost of labor is more stable than the cost of many raw materials. Thus, the expenses of a service business tend to be more predictable than a business that sells or processes products.
The most recent performance of a small business, as reflected in its income statement, may give little insight into its future performance, simply because there is a great deal of risk in running any small firm. Even the most stable small firms are vulnerable to unexpected disruptions. Because small businesses often rely on the services of the owner or a few key employees, these firms can be adversely affected or absolutely ruined if these contributions are lost or reduced. Death, disability, retirement, divorce, drug addiction, or burnout can turn a profitable business into a losing one in a very short period of time.
Any number of external events can rapidly reverse the fortunes of previously successful small retail businesses. A plant or military base closing can quickly turn a prosperous community into a struggling one. A highway relocation or reconstruction can adversely affect traffic flow and lead to dramatic declines in revenue. The appearance of a Wal-Mart, Home Depot, or Borders can spell doom to previously successful small businesses.
An income statement may tell you if a business did well or badly in the most recent period, but it does not reveal why a business performed as it did. Success or failure in business generally results from a combination of many factors, but the two key variables are management skill and luck.
Management skill is needed to insure that the right products and services are sold at the right price. Such skill is also needed to insure that customers and clients are satisfied with the products and services sold. Products and services also need to be marketed effectively. Costs must be controlled, employee morale maintained.
While management skill is an important determinant of success or failure, good and bad luck almost always play an important role in all human affairs. Good luck can allow a less than efficient business to make a profit despite its management failings. On the other hand, with bad luck a company with great management can still suffer losses. Factoring the contributions of management competence and luck in determining the firm’s reported operating results in one period is a difficult proposition. On the other hand, the ability to make profits year in and year out indicates that luck is not the only factor at work.
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