Each year, all businesses are required to file a tax return with the IRS, whether it be an 1120, an 1120S, or a 1065. Accounting firms will gather up the businesses’ information, prepare the returns, file them with the IRS, and send each client a copy of the return for their records. All too often, the client’s copy of the tax return is given just a quick glance and stuffed into a drawer where it will sit until it meets its ultimate fate in the belly of a shredder. What most business owners do not realize is that their business’ tax return is not just an expensive stack of paper; it has the potential to be a powerful analytical tool that can be used to gauge the success of the business. Tax returns are required to disclose a great deal of important information ranging from quantitative information, such as revenues and expenses, to qualitative information, such as the business’ industry … key information about certain shareholders, partners, or officers, and details about the business’ assets and liabilities. All you need to do to make the most of this information is to think like an accountant and let the numbers on the return tell you a story about your business.
The best place to start analyzing a tax return is on the very first page. Regardless of the type of return, the first page is essentially an income statement and it shows your business’ revenues, cost of goods sold, gross profit, expenses, and net taxable income. There are several basic ratios that can be calculated using these numbers. The first is the gross profit percentage and it can be calculated by taking the gross profit amount and dividing it by the gross revenues and receipts. The gross profit percentage is important because it shows what percentage of total receipts is left over after subtracting out your business’ direct costs such as direct labor and inventory expenses. A higher gross profit percentage means that your business will have more cash available to pay for general and administrative expenses, distributions, and for new assets acquisitions that will be utilized in future years. In general, the gross profit ratio of your business should remain fairly steady each year (or even better, increase). If it does not, then it may be a good idea to investigate what is causing the downward fluctuations.
Net income percentage is another important ratio that you can easily calculate. To calculate the net income percentage, take the ordinary business income at the bottom of the page and divide it by the gross revenues and receipts. This ratio shows you the percentage of your total receipts that your business has left over after it pays both direct costs as well as general and administrative expenses. Unlike the gross profit percentage, the net income percentage has the potential to fluctuate significantly from year to year, so do not be too alarmed if you notice a large change from one year to another. Take a look at the expenses and how they changed from the prior year and you should be able to determine what is causing the change in net income. The key here is looking at annual trends. If your net income percentage significantly changes from year to year, it is important to understand the factors that are driving this change.
In addition to being useful for calculating the net income percentage, the ordinary business income number on the first page of the tax return can also be useful for getting a general idea as to your business’ cash flow from operations. Since several expenses on the first page are not cash expenses, such as depreciation, depletion, and amortization, you should add back these expenses to the ordinary business income or loss to arrive at the net cash your business received, if the number is positive, or expended, if the number is negative. It is, however, important to keep in mind that this is only an approximation of your business’ cash flow from operations and the number does not take into account cash from asset purchases or sales, cash from loans paid back or received, swings in receivables and payables (if you are an accrual based taxpayer), or cash that was put in or taken out of the business. The process to calculate actual cash flow is a bit more complicated, but can usually be done fairly accurately with the assistance of an accountant.
After the first page, the next page that you can analyze is the page that contains the Schedule L. For businesses filing an 1120 or 1065, the Schedule L can be found on the fifth page and for business filing an 1120S, the Schedule L can be found on the fourth page. Basically, the Schedule L is a balance sheet and it displays all of the assets, liabilities, and equities of your business. Many analytical ratios can be calculated using the numbers on the Schedule L, but for our purposes, we will be focusing on three: the current ratio, return on assets, and the inventory turnover ratio. Each of these ratios can be calculated relatively simply, but can be important in measuring your business’ financial success.
The first of these three ratios, the current ratio, is calculated by taking total current assets and dividing them by total current liabilities. Current assets include cash, marketable securities, accounts receivable, inventories, and other highly liquid assets. On the tax return, current assets include all lines from cash through other current assets. Current liabilities include all liabilities that will come due within one year of the ending date for which the tax return is filed. On the tax return, current liabilities include all lines from accounts payable through other current liabilities. Generally, you will want the current ratio to be above one, which means that your business’ current assets are greater than current liabilities. This demonstrates that your business is in a liquid enough financial position to meet its short term debt obligations. If your business’ current ratio is below one, then you should consider ways to bolster your current assets and increase the liquidity of your business. Unforeseen expenses come up all the time and if your business is having liquidity issues, these expenses could be very damaging. Your current ratio will also provide insight into the bankability of your company. The higher the current ratio, the more attractive you are to a bank.
Return on assets is another fairly common ratio and it is used to measure how effectively your business is making use of its assets in terms of generating revenues. To calculate return on assets, take the ordinary income from page one of the tax return and divide it by your total assets on Schedule L. The resulting number shows the amount of income generated from each dollar of assets on the books of the business. Unlike the current ratio where the benchmark number is one, there is no universal benchmark for return on assets. Return on assets numbers are industry specific and the way to determine whether your business’ return on assets is solid or needs improvement is to compare it to the industry average which can be researched online.
For a business that relies primarily on selling inventory such as a retail or wholesale business, calculating the inventory turnover ratio can be very useful. The inventory turnover ratio tells you approximately how many times during the year your business was able to completely sell out its inventory. To calculate inventory turnover, you first need to determine the average carrying value of inventory during the year. To do so, take the ending inventory value of the prior year, add it to the ending inventory value of the current year, and divide by two. Then, take the cost of goods sold number from the first page of the return and divide it by the average inventory number that you just calculated. The resulting number is the number of times that your business was able to sell out or “turnover” its inventory during the year. In general, a high inventory turnover is good because it indicates that the business is experiencing good sales and also that inventory is not sitting very long before it is sold. A low inventory turnover can either be the result of poor sales or the holding of excess or obsolete inventory. There is a big downside to slow moving inventory; potential obsolescence, excess warehousing costs, tied up cash flows, etc. To get an idea as to whether your inventory turnover is good or needs improvement, you can compare it to the industry average.
These ratios and calculations are only the tip of the iceberg. There are many other ratios, some industry specific, some not, that can tell you even more about your business. So when you receive your business’ tax return copy this year, don’t just toss it into the drawer. Get the most out of your tax return and use it as a tool to learn some important things about your business that you may not otherwise have known. If you need help, we’re here for you.
This article was also featured in our newsletter Bottom Line Vol. 9
Jacob Lutz, CPA
Manager
Jacob joined Cerini & Associates in January of 2013 and has been actively providing tax, compliance, and business advisory services to a wide variety of both for-profit and non-profit clients.