How to Interpret an Expense Ratio Statement
An expense ratio is an expense expressed as a percentage of a company’s net sales, which equals sales minus the money a company loses for sales returns and discounts. An income statement that shows a company’s expense ratios for each of its expenses and total expenses is called a common-size income statement, the analysis of which is known as vertical analysis. Expense ratios help you gauge the relative size of each expense and analyze trends over different accounting periods. You can interpret a company’s common-size income statement to determine how well it manages its expenses.
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Instructions
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Review each expense ratio on a common-size income statement to determine the percentage each expense is of net sales. For example, if the common-size income statement shows administrative expenses of 15 percent, this means administrative expenses are equal to 15 percent of net sales.
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Compare each expense item on the common-size income statement over different accounting periods. Look for any abnormal increases and decreases, which may signal an increase in efficiency or a potential problem. Investigate the underlying cause of each. For example, if a company’s cost of goods sold increases from 50 percent to 70 percent between two accounting periods, this is an abnormal increase. Read a company’s financial report for the accounting period to investigate the reason.
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Identify the expense ratio for total expenses on the common-size income statement. Compare total expenses over different periods to determine an increase or decrease. A decrease means the company is spending less money on total expenses as a percentage of sales. This leads to a higher profit margin, which is net income as a percentage of sales. An increase results in a lower profit margin. For example, if a company’s total expenses decrease from 90 percent to 85 percent, the company’s profit margin increases.
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Compare each expense ratio with those of a company’s competitors and the industry averages to determine an acceptable level of expenses. Investigate any items that are abnormally higher or lower than those of its competitors. If a company has lower total expenses than its competitors, it may have a competitive advantage. For example, if a company’s total expenses are 75 percent of net sales and the industry average is 85 percent, the company may be operating more efficiently and have a competitive advantage.
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