income statement - bfa.docx

Income Statement In this module, we're going to talk about the income statement, also known as the profit and loss, or the P&L. At a very high level, what the income statement is attempting to do is to measure the operating stage of the cash cycle, and it tells us whether we're generating more c...

Income Statement In this module, we're going to talk about the income statement, also known as the profit and loss, or the P&L. At a very high level, what the income statement is attempting to do is to measure the operating stage of the cash cycle, and it tells us whether we're generating more cash than we're spending. An income statement is going to have three things on it, revenue or sales, also known as turnover in Europe or Asia, which is representative of the cash coming in, expenses, which is the cash going out, and then income or profit, which is the net cash flow of the business that we will eventually generate. But there's a couple things you need to understand about the income statement. Number one, an income statement is a period statement. We talked about the balance sheet. We called it a snapshot statement, which means it looks at a point in time. An income statement looks at activity that occurs over a period of time. Typically, for publicly traded companies, it's every three months or 12 months. Internally, companies tend to look at it on a monthly basis. But here's the point, if you really think about it, what the income statement does is it explains the activity between two balance sheets at two different points in time. So balance sheet one, income statement, balance sheet two. That's the idea of the period income statement. So here's the other thing you need to know about the income statement. The income statement tells you how much cash you will eventually generate, but timing matters and there are timing differences on an income statement. They occur under generally accepted accounting principles or GAAP because of something called the matching principle. What the accounts are trying to do is they're trying to match the period of time when you generate the revenue with the expense, and that could cause some shifting around of the sales and the revenue. So here's the point. Let's say you want to buy a computer and you spend a thousand dollars. The accountants determine that computer's going to last for three years. What they're going to do is they're going to take that thousand dollar computer and they're going to spread the cost out evenly over three years, $333.33 cents for three straight years. Now, here's the point. Every year that I show costs on my income statement of $333.33, I'm not rebuying a computer. I spent the cash today, but the cost is going to be spread out over time. That spreading out of the cost over time is a concept known as depreciation. If you ever see depreciation, what it means is a cost that's being spread out over time. This is the matching principle in action. The accountants are trying to match the cost of the asset with the time that it is being used. It will eventually be the cost that you originally spent, but again, timing matters, and that's why income statements tell you, not the cash you're generating, but income statements tell you the cash you will eventually generate. Nonetheless, they're still useful from an investor standpoint to know what cash you're eventually going to generate. So let's talk about what's actually on an income statement. We'll start at the top line, which is called sales, revenue, or turnover. Basically the volume you sell times the price you charge which represents the cash generated during the period of the statement. Next we're going to have expenses. Expenses are the costs incurred in the process of generating revenue for a business. They represent the amount of money a business spends in order to operate and generate income. They also represent the cash going out based on the activities of the period. We are then going to take our expenses and we're going to break them out into several different categories. The first category is what's known as operating expenses, which are going to be broken into direct expense, things directly associated with a product or service, and indirect expense, which are things we spend during the period that may not necessarily be directly associated with the product or service. So for example, if I build a product, then the labor and equipment and inventory for that product would be a direct expense. If I'm doing a training seminar or just marketing for my business in general, that's an indirect expense known as a selling general administrative expense. Some people will call these overhead expenses. Direct expenses are known as cost of goods sold or cost of sales. If we are looking at a manufacturing company the inventory that is made and held on the balance sheet turns into a cost of goods sold on the income statement when that item is sold. These product costs are direct expenses. If I'm looking at a service business these would be the cost directly associated with providing that service to the customer. The second category of indirect overhead costs is called Selling General and Administrative Expenses or SG&A. These could include research and development, marketing expenses, distribution expenses, corporate expenses and shared services such as legal, human resources, finance, and information technology. The third type of expense is going to be called depreciation. That's that timing difference expense that's a non-cash item we incur during the period. Next we're going to subtract the financing cost of the business, the interest expense on a company’s debt. If a company has one time or extraordinary items those are also deducted as expenses. These could include items such as a reorganization expense or a corporate layoff. After all of the expenses are deducted the company would calculate its pretax income and the company would then pay its income taxes. After the taxes are paid we will be left with the net income also known as the net profit of the business. A positive net income would reflect generating more cash then expenses during the period of time and a negative income would reflect the loss where our expenses exceeded our sales or revenue during the period of time. On the income statement we would also have some additional checkpoints along the way. The first checkpoint it's something called gross profit. Gross Profit represents sales or revenue less the direct cost of goods sold. The gross profit is what is left to pay all of the remaining expenses and eventually make a profit for the firm. We will also put our gross profit into what is known as a common size and we will take it as a percentage of sales or revenue. That is a term known as gross margin. The next checkpoint on the income statement is something called EBITDA or earnings before interest tax depreciation and amortization. To calculate EBITDA we would take our gross profit and then we would subtract our cash indirect SG&A expenses. What is left will be called EBITDA. EBITDA represents the cash profit from operating a business. From a company's EBITDA we would then subtract what is known as the DA or the depreciation and amortization expense of the firm. These are the non cash expenses that have been spread out over time to represent the matching principle of expenses. These are operating expenses but the cash for these expenses were spent in a previous. What is left after we subtract these non cash items is something called EBIT or earnings before interest and tax. Some people will also call this operating income or operating profit. This typically represents the overall performance of the operations of the business. The operating sales and revenue less the operating direct and indirect expenses. It is a key metric of the health of the business. From our EBIT we would then subtract all of the financing cost to get something called our pretax income also known as pretax profit. This is the number that we would use to estimate the taxes that we owe. After we subtract the taxes from our pre tax profit we're then left with the final bottom line which is known as net income or net profit. If we take this as a percentage of sales or revenue this is something called return on sales or RO S. From an accounting standpoint this is a key number in measuring the overall health of the business.