When one is running a business or considering buying a business, traditionally one looks at the profit margins following a calculation of the income or sales revenue minus cost of sales and variable and fixed expenses.
This approach often does not answer the questions; can I live off this business? Or What do I have to do in sales to make a living out of this business? Or Can I by this business and make an adequate living from it?
A tool to use to answer these questions is to turn the Income statement on its head, The upside -down Income statement. To produce this the entrepreneur would decide how much they would need to “take-home’ from the business. This amount might be the current take-home pay they are earning now plus an amount to make it worth your while to resign and go it alone. Or it might be the carefully worked out household budget to secure you and your loved ones a comfortable life plus provision for retirement savings.
So how does it work?
It starts with the businessperson answering the question What do I need on an hourly, weekly or monthly basis after tax to pay my living expenses add back the personal tax you would pay on that amount. This becomes the net income/profit after tax of your business.
Net Income becomes the number at the top of your upside-down income statement. This figure represents the profit after all expenses, taxes, and costs have been deducted from total sales income.
Now you add the tax and fixed expenses such as rent, electricity salaries, interest on the loan you made to buy the business etc the total you get is the Gross profit you need to fund your lifestyle
The next step is the important but tricky exercise of working out the cost of sales to add to the gross profit to get to what you must achieve in sales so if your mark-up is 100% then your cost of sales must be equal to your gross profit and the Sales you need to make is double your gross profit
So why would you build your income statement upside down. The answer is simple; it puts the pressure where it should be, on Sales and the marketing required to make those sales. For example, if your analysis shows that you must sell 2000 milkshakes per day to deliver your monthly household cash needs, you ask the question. Say, “Is this target realistic in my town with 500 households”?
So, what is the purpose of the Upside-Down Income Statement
It highlights profitability. Theres an old saying “Turnover is vanity, profit is sanity, but cash-flow is king. Any planning that puts turnover/sales first ignores the challenges of actually making money out of those sales, as impressive as they may be.
The upside-down income statement serves as an innovative tool for analysing financial performance from a different angle. By reversing the traditional format, it emphasizes the importance of profitability and cost management, allowing stakeholders to make informed decisions quickly.