Chapter 7
In This Chapter
Getting acquainted with the income statement
Considering different types of revenue
Determining a company's expenses
Analyzing a company's finances using profits and losses
Figuring out earnings per share
Every business person needs to know how well his business has done over the past month, quarter, or year. Without that information, he has no idea where his business has come from and where it may go next. Even a small business that has no obligation to report to the public is sure to do income statements on at least a quarterly or (more likely) monthly basis to find out whether the business made a profit or took a loss.
In this chapter, I review the detail that goes into an income statement, but don't be surprised if some of the detail never shows up in the financial reports you get as a company outsider. Much of the detail is considered confidential and doesn't go to people outside the company. I include this detailed information in this chapter so you know what's behind the numbers you do see. If you're a company insider, this additional information can help you understand the internal reports you receive.
The income statement is where you find out whether a company made a profit or took a loss. You also find information about the company's revenues, its sales levels, the costs it incurred to make those sales, and the expenses it paid to operate the business. These are the key parts of the statement:
When looking at an income statement, you can expect to find a report of either
Because the income statement shows profits and losses, some people like to call it the profit and loss statement (or P&L), but that isn't actually one of its official names. In addition to “statement of income,” the income statement has a number of official names that you may find in a financial report:
Income statements reflect an operating period, which means that they show results for a specific length of time. At the top of an income statement, you see the phrase “Years Ended” or “Fiscal Years Ended” and the month the period ended for an annual financial statement. You may also see “Quarters Ended” or “Months Ended” for reports based on shorter periods of time. Companies are required to show at least three periods of data on their income statements, so if you're looking at a statement for 2012, you also find columns for 2011 and 2010.
Not all income statements look alike. Basically, companies can choose to use one of two formats for the income statement: the single-step or the multistep.
Both formats give you the same bottom-line information. The key difference between them is whether they summarize that information to make analyzing it easier. The single-step format is easier to produce, but the multistep format gives you a number of subtotals throughout the statement that make analyzing a company's results easier. Most public corporations use the multistep format, but many smaller companies that don't have to report to the general public use the single-step format.
The single-step format groups all data into two categories: revenue and expenses. Revenue includes income from sales, interest income, and gains from sales of equipment. It also includes income that a company raises from its regular operations or from one-time transactions, such as from the sale of a building. Expenses include all the costs that are involved in bringing in the revenue.
The single-step format (see Figure 7-1) gets its name because you perform only one step to figure out a company's net income — you subtract the expenses from the revenue.
The multistep format divides the income statement into several sections and gives the reader some critical subtotals that make analyzing the data much easier and quicker. Even though the single-step and multistep income statements include the same revenue and expense information, they group the information differently. The key difference is that the multistep format has the following four profit lines:
Many companies add even more profit lines, like earnings before interest, taxes, depreciation, and amortization, known as EBITDA for short (see the section “EBITDA,” later in this chapter).
Some companies that have discontinued operations include that information in the line item for continuing operations. But it's better for the financial report reader if that information is on a separate line; otherwise, the reader doesn't know what the actual profit or loss is from continuing operations. I delve a bit deeper into these various profit lines in “Sorting Out the Profit and Loss Types,” later in this chapter.
Figure 7-2 shows the multistep format, using the same items as in the single-step format example (refer to Figure 7-1).
You may think that figuring out when to count something as revenue is a relatively simple procedure. Well, forget that. Revenue acknowledgment is one of the most complex issues on the income statement. In fact, you may have noticed that, with the recent corporation scandals, the most common reason companies have gotten into trouble has to do with the issue of misstated revenues.
In this section, I define revenue and explain the three line items that make up the revenue portion of the income statement: sales, cost of goods sold, and gross profit.
When a company recognizes something as revenue, it doesn't always mean that cash changed hands, nor does it always mean that a product was even delivered. Accrual accounting leaves room for deciding when a company actually records revenue. A company recognizes revenue when it earns it and recognizes expenses when it incurs them, without regard to whether cash changes hands. You can find out more about accounting basics in Chapter 4.
When a company wants to count something as revenue, several factors can make that decision rather muddy, leaving questions about whether a particular sale should be counted:
For example, when a company is in the middle of negotiating a contract for a sale of a major item such as a car or appliance, it can't include that sale as revenue until the final price has been set and a contract obligating the buyer is in place.
For example, publishers frequently allow bookstores to return unsold books within a certain amount of time. If there's a good chance that some portion of the product may be returned unsold, companies must take this into account when reporting revenues. For instance, a publisher uses historical data to estimate what percentage of books will be returned and adjusts sales downward to reflect those likely returns.
No, I'm not talking about kissing cousins here. I'm talking about when the buyer is the parent company or subsidiary of the seller. In that case, companies must handle the transaction as an internal transfer of assets.
For example, a toy company works with a distributor or other middleman to get its toys into retail stores. If the middleman doesn't have to pay for those toys until they're delivered or sold to retailers, the manufacturer can't count the toys it shipped to the middleman as revenue until the middleman completes the sale.
For example, many manufacturers of technical products offer installation or follow-up services for a new product as part of the sales promotion. If those services are a significant part of the final sale, the manufacturer can't count that sale as revenue until the installation or service has been completed with the customer. Items shipped for sale to local retailers under these conditions aren't considered sold, so they can't be counted as revenue.
Not all products sell for their list price. Companies frequently use discounts, returns, or allowances to reduce the prices of products or services. Whenever a firm sells a product at a discount, it needs to keep track of those discounts, as well as its returns and allowances. It's the only way the company can truly analyze how much money it's making on the sale of its products and how accurately it's pricing the products to sell in the marketplace.
As a financial report reader, you don't see the specifics about discounts in the income statement, but you may find some mention of significant discounting in the notes to the financial statements. Here are the most common types of adjustments companies make to their sales:
Internally, managers see the details of these adjustments in the sales area of the income statement so that they can track trends for discounts, returns, and allowances. Tracking such trends is an important aspect of the managerial process. If a manager notices that any of these line items show a dramatic increase, she needs to investigate the reason for the increase. For example, an increase in discounts may mean that the company has to consistently offer its products for less money, which then may mean that the market is softening and fewer customers are buying fewer products. A dramatic increase in returns may mean that the products the business is selling have a defect that needs to be corrected.
Like the Sales line item, the Cost of goods sold (what it costs to manufacture or purchase the goods being sold) line item has many different pieces that make up its calculation on the income sheet. You don't see the details for this line item unless you're a company manager. Few firms report the details of their cost of goods sold to the general public.
Items that make up the cost of goods sold vary depending on whether a company manufactures the goods in-house or purchases them. If the company manufactures them in-house, you track the costs all the way from the point of raw materials and include the labor involved in building the product. If the company purchases its goods, it tracks the purchases of the goods as they're made.
In fact, a manufacturing firm tracks several levels of inventory, including
Sometimes tracking begins from the time the raw materials are purchased, with adjustments based on discounts, returns, or allowances given. Companies also add to the income statement's cost of goods sold section freight charges and any other costs involved directly in acquiring goods to be sold.
When a company finally sells the product, it becomes a Cost of goods sold line item. Managing costs during the production phase is critical for all manufacturing companies. Managers in this type of business receive regular reports that include the cost details. Trends that show dramatically increasing costs certainly must be investigated as quickly as possible because the company must consider a price change to maintain its profit margin.
The Gross profit line item in the income statement's revenue section is simply a calculation of net revenue or net sales minus the cost of goods sold. Basically, this number shows the difference between what a company pays for its inventory and the price at which it sells this inventory. This summary number tells you how much profit the company makes selling its products before deducting the expenses of its operation. If the company shows no profit or not enough profit here, it's not worth being in business.
Managers, investors, and other interested parties closely watch the trend of a company's gross profit because it indicates the effectiveness of the company's purchasing and pricing policies. Analysts frequently use this number not only to gauge how well a company manages its product costs internally, but also to gauge how well the firm manages its product costs compared with other companies in the same business.
If profit is too low, a company can do one of two things: find a way to increase sales revenue or find a way to reduce the cost of the goods it's selling.
To increase sales revenue, the company can raise or lower prices to increase the amount of money it's bringing in. Raising the prices of its product brings in more revenue if the same number of items is sold, but it may bring in less revenue if the price hike turns away customers and fewer items are sold.
Lowering prices to bring in more revenue may sound strange to you, but if a company determines that a price is too high and is discouraging buyers, doing so may increase its volume of sales and, therefore, its gross margin. This scenario is especially true if the company has a lot of fixed costs (such as manufacturing facilities, equipment, and labor) that it isn't using to full capacity. The firm can use its manufacturing facilities more effectively and efficiently if it has the capability to produce more product without a significant increase in the variable costs (such as raw materials or other factors, like overtime).
A company can also consider using cost-control possibilities for manufacturing or purchasing if its gross profit is too low. The company may find a more efficient way to make the product, or it may negotiate a better contract for raw materials to reduce those costs. If the company purchases finished products for sale, it may be able to negotiate better contract terms to reduce its purchasing costs.
Expenses include the items a company must pay for to operate the business that aren't directly related to the sale and production of specific products. Expenses differ from the cost of goods sold, which can be directly traced to the actual sale of a product. Even when a company is making a sizable gross profit, if management doesn't carefully watch the expenses, the gross profit can quickly turn into a net loss.
Advertising and promotion, administration, and research and development are all examples of expenses. Although many of these expenses impact the ability of a company to sell its products, they aren't direct costs of the sales process for individual items. The following are details about the key items that fit into the expenses part of the income statement:
When you hear earnings or profits reports on the news, most of the time, the reporters are discussing the net profit, net income, or net loss. For readers of financial statements, that bottom-line number doesn't tell the entire story of how a company is doing. Relying solely on the bottom-line number is like reading the last few pages of a novel and thinking that you understand the entire story. All you really know is the end, not how the characters got to that ending.
Because companies have so many different charges or expenses unique to their operations, different profit lines are used for different types of analysis. I cover the types of analysis in Part III, but in this section, I review what each of these profit types includes or doesn't include. For example, gross profit is the best number to use to analyze how well a company is managing its sales and the costs of producing those sales, but gross profit gives you no idea how well the company is managing the rest of its expenses.
Using operating profits, which show you how much money a company made after considering all costs and expenses for operating, you can analyze how efficiently the company is managing its operating activities, but you don't get enough detail to analyze product costs.
A commonly used measure to compare companies is earnings before interest, taxes, depreciation, and amortization, also known as EBITDA. With this number, analysts and investors can compare profitability among companies or industries because it eliminates the effects of the companies’ activities to raise cash outside their operating activities, such as by selling stock or bonds. EBITDA also eliminates any accounting decisions that may impact the bottom line, such as the companies’ policies relating to depreciation methods.
How a firm chooses to raise money can greatly impact its bottom line. Selling equity has no annual costs if dividends aren't paid. Borrowing money means interest costs must be paid every year, so a company will have ongoing required expenses.
EBITDA gives financial report readers a quick view of how well a company is doing without considering its financial and accounting decisions. This number became popular in the 1980s, when leveraged buyouts were common. A leveraged buyout takes place when an individual or company buys a controlling interest (which means more than 50 percent) in a company, primarily using debt (up to 70 percent or more of the purchase price). This fad left many businesses in danger of not earning enough from operations to pay their huge debt load.
Today EBITDA is frequently touted by technology companies or other high-growth companies with large expenses for machinery and other equipment. In these situations, the companies like to discuss their earnings before the huge write-offs for depreciation, which can make the bottom line look pretty small. Be aware that a company can use EBITDA as an accounting gimmick to make earnings sound better to the general public or to investors who don't take the time to read the fine print in the annual report.
If a company earns income from a source that isn't part of its normal revenue-generating activities, it usually lists this income on the income statement as nonoperating income. Items commonly listed here include the sale of a building, manufacturing facility, or company division. Other types of nonoperating income include interest from notes receivable and marketable securities, dividends from investments in other companies’ stock, and rent revenue (if the business subleases some of its facilities).
Companies also group one-time expenses in the nonoperating section of the income statement. For example, the severance and other costs of closing a division or factory appear in this area, or, in some cases, the statement has a separate section on discontinuing operations. Other types of expenses include casualty losses from theft, vandalism, or fire; loss from the sale or abandonment of property, plant, or equipment; and loss from employee or supplier strikes.
You usually find explanations for income or expenses from nonoperating activities in the notes to the financial statements. Companies need to separate these nonoperating activities; otherwise, investors, analysts, and other interested parties can't gauge how well a company is doing with its core operating activities. The Core operating activities line item is where you find a company's continuing income. If those core activities aren't raising enough income, the firm may be on the road to significant financial difficulties.
A major gain may make the bottom line look great, but it can send the wrong signal to outsiders, who may then expect similar earnings results the next year. If the company doesn't repeat the results the following year, Wall Street will surely hammer its stock. A major one-time loss also needs special explanation so that Wall Street doesn't downgrade the stock unnecessarily if the one-time nonoperating loss won't be repeated in future years.
In addition to net income, the other number you hear almost as often about a company's earnings results is earnings per share. Earnings per share is the amount of net income the company makes per share of stock available on the market. For example, if you own 100 shares of stock in ABC Company and it earns $1 per share, $100 of those earnings are yours unless the company decides to reinvest the earnings for future growth. In reality, a company rarely pays out 100 percent of its earnings; it usually pays out a small fraction of those earnings.
Basically, earnings per share shows you how much money each shareholder made for each of her shares. In reality, this money doesn't get paid back to the shareholder. Instead, most is reinvested in future operations of the company. The net income or loss is added to the retained earnings number on the balance sheet.
Any dividends declared per share appear on the income statement under the earnings per share information. You find the amount of dividends paid on the statement of cash flows, which I talk about in Chapter 8. The company's board of directors declares dividends either quarterly or annually.
At the bottom of an income statement, you see two numbers:
These numbers give you an idea of how much a company earns per share. You can use them to analyze the company's profitability, which I show you how to do in Chapter 11.