MBA in 2 minutes: Lesson 3: What is the first step you take when profits decline
Updated: Jan 8, 2021
After giving limelight to statisticians and economists, we move to accountants.
Declining profits is a common issue in many organisations. If not at an organization level, then you might have been asked or will be asked to diagnose the issue at department level.
The first and foremost step one should take is to open Income Statements. Non CAs don't get hassled by it. Reading income statements is a fantastic skill to have in your kitty. As a professional with no prior finance background, I too have been intimidated by it with the reason being too many line items and too many numbers.
In this lesson we will aim to simplify the process.
Once we talk of profits you need to check if we are talking of EBIT i.e. earnings before income tax or earnings after. And why is that important ? Because you need to define scope or boundary of your diagnosis . For eg in case of earnings after tax : you can explore scope of increasing profits by seeing scope of tax reduction (which involves another topic discussion).
Now, let's look at the picture below. It has A) Revenues B) Expenses. This is all you care about. That's it. Everything else is a sub set of it. When the profits are declining, you do 2 things:
1. Open own organization/department's historical income statements and check if revenue has been decreasing or cost has been increasing .
2. If your organisation is publicly traded then open closest publicly traded competitor's income statement also. Check competitor's profits trends /revenue trends/ cost trends. You will be able to understand industry patters whether revenue is down industry wide for eg: auto industry case in India in contemporary space or you might be able to figure out that competition is eating a share of your pie in terms of revenue.
You will be able to understand the above 2 once you are not intimidated by income statement and can simplify things i.e. Profits= Revenue- Costs. Now let's say you figured out that the cost is rising the next step is to look at sub headings to see exactly which cost item is the bad boy.
Offcourse this is the starting step, you will find complex looking income statements where the costs might be segmented into operating cost such as COGS: Cost Of Goods Sold and non operating costs such as interest on loan etc.
Once you get hold of the problem area then you get to the 5 why analysis i.e. why is the cost rising and then you spend time on fixing it which is the kind of problems management consultants work day in and out. Simple ? Right ! It is indeed. As managers you don't need to create income statements. We have talented CAs for that. However you need to learn how to read them, hold a conversation and get relevant information.
Now if you could spend 5 more minutes I am sharing income statements of 2 publicly traded Indian companies. Complete the drill step by step as we discussed.
(In company B, you would have to Ctrl+F for term "income statement")
This brings to the end of Lesson 3.
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