In my work with small businesses I’ve found that many owners do not take the time to analyze their financial results on a regular basis. Some don’t know how to do it but most just don’t take the time to do it. Why do something that is important and not urgent when you have other things to do that are urgent, important or not?
When tackling financial data and analysis, adopting a Top-Down Analysis approach can offer a more streamlined and effective path to understanding. This method emphasizes using a big-picture view first before delving into finer details—an approach that contrasts with traditional bottom-up strategies which often start with specific and detailed elements. Start big and drill down into the detail only where needed. You don’t need to look at every line item.
A TOP-DOWN INCOME STATEMENT
Before we get into the approach we need a new tool. I introduced the Top-Down Income Statement in a paper published in June 2008 in Strategic Finance, a publication by the Institute of Management Accountants. The paper is called Making More Time for Effective Financial Analysis.
Traditionally, income statements, also known as profit and loss statements, are structured in a way that requires reviewing revenue items then expense items to eventually reach the Operating Income. Income statements have been this way since they were first used hundreds of years ago because the accountant had to calculate the revenue and expenses to get to the “bottom line” (Operating Income) *. This order does not align with how one should prioritize their analysis.
Consider reworking the income statement to prioritize the most crucial number—the Operating Income—at the top. See Figure 1 for a simplified traditional income statement and Figure 2 for a Top-Down Income Statement. The "Top-Down" Income Statement format places the most critical figures first and organizes details in descending order of importance. With spreadsheets and financial software, we have the flexibility to redesign income statements to reflect a Top-Down perspective, focusing on the most important elements first and exploring supporting details as needed.
Figure 1:
Figure 2:
SO WHAT IS THE TOP-DOWN APPROACH?
Top-Down Analysis begins by deciding what you will measure your income statement against. In large companies it is common to compare financial results to a budget or forecast, their financial plan. Most small businesses don’t have budgets or forecasts so good comparisons include the same period in the prior year, the previous period, or a trend of the previous months in the current year – any will do.
The next step is to focus on the most important element. In an income statement that is Operating Income. How is your Operating Income compared to the same period last year? If it looks pretty good you might be tempted to move on to other business tasks, but you might be missing some performance elements moving in opposite directions and offsetting.
So you then drill down to the next level components of Operating Income – Gross Margin and Expenses. How do they look compared to your measurement period? If Gross Margin is off you can determine its cause by drilling down to Revenue and Cost of Goods Sold. You can then drill down further into either or both of these elements. Once you find your answers, immediately move back to the top and go down the next path – for example drilling down into Expenses.
This method not only saves time but also ensures that attention is directed to the areas that have the greatest impact on the overall performance. If a company is meeting its overall profit targets, it may be less critical to dissect every account’s performance. Sometimes, it’s about accepting that not every detail needs to be scrutinized if it doesn’t significantly affect the top-line results.
Now let’s get real for a minute. Your accounting software probably does not give you the reporting capability to create a Top-Down Income Statement. You can use the Top-Down approach on a standard Income Statement. You just need to make sure you focus on the hierarchy of the line items and the just the significant variances.
BENEFITS OF TOP-DOWN ANALYSIS
Time Efficiency
By concentrating on critical elements and major variances first, you avoid getting bogged down by less significant details. This method accelerates the decision-making process, allowing for quicker and more informed actions.
Focused Attention
Focusing on high-level insights rather than being overwhelmed by the smallest details helps in maintaining clarity and effectiveness in decision-making. This structured approach ensures that you address the most impactful elements first.
Enhanced Clarity
With a Top-Down approach, the complexity of data is simplified. You deal with the bigger picture and major issues first before addressing specific details, ensuring a more organized and manageable analysis.
Top-Down Analysis is a powerful tool for anyone that doesn’t have a lot of time to analyze their financial statements. By starting with the most important elements and working down to the necessary details, you can streamline your analysis, save time, and maintain a clearer focus on what truly matters. Embracing this method can lead to more strategic decision-making and a better understanding of key performance indicators without getting lost in the details. It will help you “see the story in your numbers”.
* Technically, Net Income is the “bottom line” since it reflects Operating Income plus Other Income and less Other Expenses. I am using Operating Income because Other Income and Expenses are non-operational, so it is the best representation of how a business is performing.
(P.S. tap the photo below)
Comments