Declining Net Income

Q: Over past 10 years, our service company’s Revenue and Long-Term Liabilities have increased while Retained Earnings, Equity, and Net Income have decreased. Any observations and/or counsel?

A: While it is somewhat difficult to answer the question without additional information, the most likely scenario is that your Expenses are rising faster than your Revenue and — as an owner — you continue to take out the same salary/distributions that is affecting most or all of the Net Income and the shortfall is being made up by taking on more Long-Term Liabilities.

To illustrate the point, here is an example of a summarized Income Statement and Balance Sheet of a ficticious company that experiences what one would normally expect to see:

  • Direct Expenses that decrease slightly as a percentage of Revenue with increases in Revenue due to scale economies and the learning curve
  • Indirect Expenses that decrease slightly as a percentage of Revenue with increases in Revenue due to operating leverage
  • Net Income stays in the company to finance working capital and growth needs
  • Liabilities increase along with the increase in Revenue (typical Working Capital requirements that tend to increase with size)
  • Total Net Worth (Owner’s Equity and Retained Earnings) increases over time

NW Example 1

To further illustrate the point, here is an example of a summarized Income Statement and Balance Sheet of a ficticious company that experiences a situation similar to what you describe:

  • Direct Expenses that increase as a percentage of Revenue with increases in Revenue (the opposite of what one would expect)
  • Indirect Expenses that decrease slightly as a percentage of Revenue with increases in Revenue due to operating leverage
  • Net Income is taken out of the company to finance the owner’s lifestyle needs
  • Liabilities increase along with the increase in Revenue as well as the reduced profitability and the lack of earnings left in the company
  • Total Net Worth (Owner’s Equity and Retained Earnings) decreases over time

NW Example 2

I’d suggest a detailed financial model and analysis to fully ascertain the issue by starting with a simple model as illustrated above as a starting point and then building out the analysis from there. We have Crown Business Advisors that can help you with that analysis if you would like some assistance.

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About Wade Myers

Wade has founded or co-founded, invested in, and been a director of over 25 companies and has completed 55 financing and M&A transactions. His previous work experience includes the Boston Consulting Group and Mobil Corporation. Wade also served as an Airborne Ranger in the US Army where he was a decorated veteran of the Gulf War. He is a Baker Scholar graduate of Harvard’s MBA program and is married with five children.

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