This article discusses relative measures of economic performance derived from the raw numbers on an income statement.
It often can be very difficult to measure a firm’s economic performance in any absolute sense. Financial statements are in general much better at reflecting relative measures of economic performance. Relative measures include comparisons between this year’s economic performance and prior years, or this year’s performance compared with expected or budgeted performance. If reliable comparative data is available, it is sometimes possible to compare one company’s performance against the performance of other businesses in the same field.
Comparing the raw numbers on financial statements over several accounting periods can yield misleading interpretations of economic performance for several reasons. First, over several periods of time the value of the dollars reported on financial statement change, due to inflation or deflation. To a certain extent, this problem can be overcome by adjusting the raw numbers using a price index, which attempts to equalize the purchasing power of dollars over different accounting periods. These indices are far from perfect, but they do help when comparing the raw numbers on multi-year financial statements. However, smaller firms may find use of these indices cumbersome.
Another problem in comparing raw numbers on financial statements is that over many accounting periods the nature and size of a firm’s activity can change dramatically. In the start-up period, the volume of sales is not likely to be as great as when the business matures. Also, the mix of products and services offered by a business may change dramatically over time.
To compensate for changes in the value of the dollar and changes in the scope and nature of business activities, financial statements are often converted to percentages. In converting raw numbers on an income statement to percentages, the total revenue or sales figure is usually used as the basis for percentage conversion. If a business has $100,000 in total revenue, this is converted to 100%. All expenses are converted to percentages by dividing the raw expense numbers into the raw total revenue number. For example if the firm incurs $30,000 of salary expenses, salary expenses would be shown at 30% (30,000/100,000). If the raw number for advertising was $4,500 then the percentage for this expense is 4.5% (4,500/100,000). The Joint Ventures’ Income Statement below illustrates the conversion of raw numbers to percentages.
How does the conversion of raw numbers to percentages improve the usefulness of multi-period statements? Despite changes in the value of the dollar or the scope of a firm’s operations, the relationships between categories of revenue and expenses often remain relatively consistent. Wide variations in percentages from period to period indicate that significant changes in the structure and nature of the operations have taken place.
The stability of the relationship between income and expense items explains how historical operating results can be used to construct operating budgets for future periods. For example, a company may expect its sales to decrease or increase significantly. If certain expenses have shown a stable percentage relationship to total revenue in the past, specific dollar amounts for these expenses can be budgeted, based on the expected dollar amount of revenue.