Chapter 2
In this Part
Surveying the parts of the income statement
Evaluating the income statement for quality of earnings
SINGLE-STEP INCOME STATEMENTS
Many companies prefer to use single-step income statements, particularly for minor reports that aren’t annual or quarterly.
The big difference between the multiple-step income statement and the single-step income statement is that the single-step statement doesn’t separate costs and revenues by their source operations. Instead, it lists all income, breaking it down into net sales and other, and then lists all costs, with a total of the costs. Finally, it lists earnings before interest and taxes (EBIT), taxes, net income, and earnings per share (EPS). It’s a much shorter method of reporting earnings, but it isn’t nearly as informative as the multiple- step statement.
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Corporate income statements work a lot like your personal finances: You start with the amount of money you make and then subtract all your costs to find out how much you have left to put in the bank, buy a new vacation home, or join a professional Ping-Pong team.
The main difference is that corporate income statements probably include more information overall than your personal income statement. In fact, a company’s income statement breaks down how much money it’s making versus how much it’s spending into six main categories. Together, these six categories detail the company’s costs and revenues, separating them by their source operations. I cover each of these categories in the following sections.
Gross profit
The first portion of the income statement, called gross profit, seeks to calculate the profitability of a company’s operations after direct costs. Its ultimate goal is to determine the company’s gross margin.
For example, if you’re a self-employed window washer, your margin is all the money you make for washing windows, minus the cost of the materials you used to wash those windows (for example, soap, water, and other supplies), but not the cost of your ladder because you use it over and over again.
Net sales
Net sales is all the money that a company makes from its primary operations. If the company is a retailer, then net sales includes all the money the company gener- ates from selling retail goods. If the company is a lawn service but it also offers tree trimming, then net sales includes the money it makes from both services.
However, it doesn’t include any money made from other activities outside of its core operation(s). So no counting the extra money made from selling an old lawnmower.
To get net sales, don’t subtract any costs yet. Net sales includes every last dime a company makes from sales; the costs come into play later.
Some companies refer to net sales as gross income, income from sales, or some other similar term. Just remember that net sales is always the very first item on the income statement, regardless of what a company calls it.
Cost of goods sold
To make a product or provide a service, a company has to purchase supplies. Maybe a tool manufacturer needs to buy steel. Maybe a window washing company needs to buy soap and water. Maybe a tutoring company just needs to pay its tutors. No matter what its primary operation is, every company adds up all the direct costs it incurs as a result of actually making its product or service, not including indirect costs (sales costs, administrative costs, research costs, and so on), and includes them under cost of goods sold (COGS) on the income statement. The very nature of this section lies within its name: It’s the cost a company has incurred in making or buying the goods that it has sold.
Just like the price of beer changes at the store from time to time, the costs of those things a company purchases can change. So when the things a company purchases change, it must choose how it will measure the cost of goods sold. The two pri- mary ways a company can account for the costs of goods sold are
» FIFO (first-in, first-out): With this method, a company will use the costs of those things it purchased earliest when accounting for COGS. In other words, the first inventory made or bought is the first inventory to be sold.
» LIFO (last-in, first-out): With this method, a company will use the cost of those things it purchased most recently when accounting for COGS. In other words, the most recent inventory made or bought is the first inventory to be sold.
Because the value of inventory minus costs influences all other financial state- ments, a company must choose to use either FIFO accounting or LIFO accounting and stick with it for everything. If a company chooses to switch from one method to another, it must describe the change, including the calculated change in value resulting from the change in method. It describes this change in the supplemen- tary notes of at least the income statement and typically all the other financial statements, as well.
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Gross margin
The last part of the gross profit portion of the income statement is the gross mar- gin, which you get by subtracting the cost of goods sold from the net sales. The gross margin is all the money a company has left over from its primary operations to pay for overhead and indirect costs, like the sales staff, building rent, janitorial services, and everything else that’s not directly related to the production or pur- chase of inventory.
When you divide gross margin by net sales, you get the percentage of net sales that isn’t spent on producing the inventory. This percentage is extremely impor- tant in evaluating a company’s ability to fund supporting operations, plan growth, and create budgets. The gross margin, sometimes called just margin, also comes into play in a number of metrics that I describe in Chapters 7 and 8.
Operating income
The next portion of the income statement takes into account the rest of a com- pany’s costs of doing business (other than the costs of goods sold) and is called operating income. Think of it as a way of breaking down the overhead costs associ- ated with all the standard operations without including any infrequent revenues or costs. The overall goal of the operating income is to determine how much money a company is making after taking into consideration all the costs the com- pany incurs during its primary and supporting operations. Here’s what goes into the operating income:
» Selling expense: This includes everything a company spent on selling the products it bought or made, such as advertising, sales wages or commissions, shipping, and the cost of retail outlets. The cost of opening a retail outlet may be a selling expense, or perhaps just the cost of a sales team may be a selling expense — anything at all related or attributed exclusively to the sales process, whether entirely or in part.
» General and administrative costs: Also called G&A costs, these cover all the expenses of running a company. The salaries of the finance, marketing, human resources, and management staff fall into this category, as do the salaries of everyone who isn’t directly associated with making or selling the inventory. Other costs that fall into this category include the costs of buildings, utilities, office supplies, insurance, office equipment, decorations, and a wide variety of other stuff. Any time a company spends money on an expense that keeps the company going but that isn’t related to production or sales, it goes into the G&A costs.
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» Depreciation and amortization: The income statement includes a section for depreciation and amortization, but it doesn’t reveal anything about a physical transition of money from one party to another. Rather, this section simply recognizes the use of items that will lose value. The amount of depreciation listed on the income statement is the same as the amount incurred during a single period that gets added to the balance sheet.
The depreciation and amortization value on the income statement isn’t the same value that appears on the balance sheet because the balance sheet is cumulative while the income statement includes only depreciation incurred that year. But the amount of depreciation incurred in the year will go into the balance sheet’s cumu- lative total.
To get the operating income, you just add up all the costs listed in the preceding three sections and then subtract that number from the gross margin. Because the operat- ing income represents the amount of money a company has left over after it has paid for all its standard operations, companies need to consider it when planning whether to expand, whether to use equity or debt to fund expansion, and how much money they can borrow and safely pay back using their primary operations. Operating income is also useful in other metrics, such as liquidity, which I cover in Chapter 7.
Earnings before interest and taxes (EBIT)
Over the course of doing business, a company incurs costs or generates income from a number of activities that aren’t related to the company’s normal operations. The goal in this portion of the income statement is to account for all these other costs and revenues so the company can make smart financial decisions on debt and so it knows how much to pay in taxes. The final calculation in this portion is called earnings before interest and taxes (EBIT), and it includes the following elements:
» Other income: This includes anything the company does other than its main business that generates income. For example, a company that has an extra office in its building that it isn’t using can rent that office out to others, thereby generating other income. Similarly, a company can sell off a piece of old equipment to buy new equipment. The money it makes by selling the old equipment falls into the other income category.
» Other expenses: This includes anything the company does other than its main business that incurs costs. As with other income, other expenses can vary widely. If a company spends or loses money that doesn’t belong in any other category, it counts here. Taxes are one of the most common other expenses a company incurs. Companies can include any taxes they must pay, other than income taxes, in this portion. Income taxes go in the net income portion of the income statement (see the next section).
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» Profit/loss for discontinued operations: Any time a company decides to stop pursuing one or more of its operations, the amount of profit or loss experienced from stopping, as well as the amount generated from running those operations up until that point, goes here. In other words, if a company is losing money on some operation and it decides to stop that operation halfway through the period, the amount of money the company lost up until that period is included here. In addition, any money the company received from selling the equipment for that operation or paying off lawsuits for the operation is included here.
You calculate EBIT by taking gross margin and then subtracting or adding the dif- ferent sources of costs and revenues associated with nonprimary business opera- tions. Essentially, earnings before interest and taxes is the total amount the company made before lenders and the government get their hands on the com- pany’s profits. It’s an important value for companies and investors to consider because this income statement item shows how much money the company is making and how much it has to pay in taxes. For example, a company that’s mak- ing less money this year than last year will pay less taxes. So, all in all, the earn- ings before interest and taxes determine whether a company can make money the way it’s currently operating.
Net income
The final portion of the income statement that lists costs and revenues is called net income and deals exclusively with taxes and interest. A company has to pay the taxes and interest charges that appear in this section, but the amounts due are often related to the amount of money the company makes. As a result, the com- pany has to account for all other expenses and revenues before it can calculate these final items and determine the company’s total profits. Here’s a breakdown of what goes into net income:
» Interest income: A company can earn interest when it has some types of bank accounts, when it owns bonds or other forms of debt on individuals or companies, or when it purchases money-market investments like certificates of deposit. All this interest falls under interest income on the income statement.
» Interest expense: A company can generate interest expense when it borrows money from a bank or other organization or when it issues bonds. All the interest that a company pays, regardless of where the interest expense comes from, goes into the interest expense portion of the income statement.
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» Income tax expense: Like people, companies must pay taxes on the income they generate. The amount of income taxes a company pays is based on their EBT (earnings before tax, but not interest). So if a company makes $100 in a tax year and it has to pay 6 percent in income tax, then it has to pay $6. Many companies also list the percentage of income taxes in this section, but it isn’t required.
Net income is calculated by taking EBIT and subtracting all interest and tax expense. Simply put, the net income is the final amount that a company walks away with after it has considered all costs. It includes all revenues and all costs and represents the final profits that a company was able to generate during the period. The company must either distribute the money from net income to its stockholders (who own the company) or reinvest it into the company for improve- ments and expansion. Either way, the money from net income belongs to the company owners and must contribute to the value of their ownership in the company.
Earnings per share
In the portion of the income statement immediately following net income, corpo- rations have to include the amount of earnings each share of stock they have out- standing has generated. Here are the two main components of this portion, aptly called earnings per share (EPS):
» Basic earnings per share: Companies calculate the basic earnings per share by dividing net earnings by the total number of common shares outstanding. This calculation tells investors how much money each share of stock they own earned during the period. For example, if a company made $1,000 during a year and has a total of 1,000 shares of stock, then everyone who owns that company’s stock made $1 per share of stock.
» Diluted earnings per share: Companies can issue a number of options that can eventually turn into common stock. For example, company employees may be given stock options, or preferred shares and convertible bonds may be converted into common stock. The diluted earnings per share does the same thing as basic earnings per share except that it assumes all these different holding options have been turned into common shares. So a company that made $1,000 and has 1,000 shares of stock has an earnings per share of $1. But if that company also has 1,000 shares of convertible pre- ferred stock, its diluted earnings per share is $0.50.
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Supplemental notes
Sometimes events that alter a company’s income occur but don’t have a place on the income statement or require additional comments. Anything of this sort goes in the supplemental notes portion of the income statement. Examples include the following:
» A switch from LIFO inventory cost accounting to FIFO inventory cost accounting
» An unusual or infrequent event, such as finding an oil reserve where your new building is being constructed and selling it for extra revenues
» Any discontinued operations or unusual earnings from subsidiaries
Learning about Liabilities
Liabilities include those accounts and debts that a company must pay back. Like assets, liabilities usually fall into two main categories:
» Current liabilities: Liabilities that must be paid back, fully or in part, in less than one year
» Long-term liabilities: Liabilities that must be paid back in a time period of one year or more
Current liabilities
This section lists the current liabilities you find on the balance sheet in order from those that must be paid in the shortest period from when they were incurred to those that can be paid off in the longest period from when they were incurred.
Accounts payables
Accounts payables include any money that’s owed for the purchase of goods or ser- vices that the company intends to pay within a year. Say, for instance, that a company purchases $500 in paper clips and plans to pay that amount off in six months. The company adds $500 to the value of its accounts payables. But after the company pays an invoice for the money it owes, it removes the value of that invoice from the accounts payables.
Unearned income
When a company receives payment for a product or service but has yet to provide the goods or services it was paid for, the value of what the company owes the cus- tomer contributes to its unearned income. Imagine, for example, that you own a
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dog polishing business that charges $10 per session. One of your customers pays $120 for monthly sessions, so your unearned income for that customer is $120 at the start. That value decreases by $10 every month as you provide the services that the customer paid for in advance.
Accrued compensation and accrued expenses
As a company utilizes resources such as labor, utilities, and the like, it must even- tually pay for these resources. However, most companies make such payments once every week, two weeks, three weeks, month, and so on, not upon receipt of the resource.
» Accrued compensation refers to the amount of money that employees have earned by working for the company but haven’t been paid yet. Not that the company is refusing to pay, necessarily, just that people tend to get paid once every one to four weeks. So until these people receive their paychecks, the amount that the company owes them is considered a liability.
» Accrued expenses work in a similar way and are applied to such things as rent, electricity, water, and any other expenses that a company incurs and pays at regular intervals.
Deferred income tax
For tax purposes, sometimes a company chooses to report its income in a different period than when it actually earned the income. Although deferred income tax, as it’s called, can be quite useful for businesses in their attempt to reduce tax expenses in any given year, it does provide an additional concern for analysts. To clarify just how much a company owes in deferred income taxes, the company reports this amount in the liabilities portion of the balance sheet.
Current portion of long-term debt
Often companies pay long-term debt in small portions over the course of several years. The current portion of long-term debt that a company has to pay in the next year is subtracted from long-term liabilities (see the next section) and added as a part of the short-term liabilities. Not all companies include this category on their balance sheets, but it’s extremely common.
Other current liabilities
Companies include any liabilities that they have to pay within the next year and that they don’t specify elsewhere on the balance sheet in the liability category creatively called other current liabilities. This category can include a wide variety of things from royalties to interest to rebates and everything in between.
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Long-term liabilities
This section outlines the categories you see in the long-term liabilities section of the balance sheet.
Notes payable
When a company owes money that it expects to pay in a time period that’s longer than one year, the value of that money goes into a category called notes payable. Often this category includes all loans and debt that the company is expected to pay over the long run. However, some companies choose to include any payments on bonds held for more than one year in a separate category called bonds payable.
Capital lease obligations
When a company leases a piece of capital, the total amount owed on that lease adds to the value of the capital lease obligations category of liabilities. As the com- pany gradually pays the lease, each payment causes a deduction from this liability.
Eyeing Owners’ Equity
The owners’ equity portion of the balance sheet breaks down exactly what value the company has to its owners and how that value is allocated to them. The amount of value that investors have in a corporation is equivalent to the amount of total assets the company has minus its total liabilities.
In all cases, regardless of any other variables, debtors always get their cut in a company’s assets before investors. Just as you must take into consideration all the money you owe when calculating your personal net worth, so must every com- pany. Owners don’t get anything until lenders get their money back.
This section goes over the subsections that fall under the owners’ equity portion of the balance sheet. The first three cover different types of stock, while the last three go over other types of earnings and income.
Preferred shares
Company ownership is measured in shares of stock, but the types of stock vary. The first one listed on the balance sheet is called preferred shares. Preferred shares take precedence over all other types of stock in several different ways. First of all, preferred stockholders are guaranteed dividends, which means they always get
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their payments before common shareholders get theirs (see the next section). If the preferred holders don’t get their guaranteed dividends one year, those divi- dends accumulate into the next year. Holders of preferred shares also get their full value in the liquidation of the company should it go out of business before holders of common shares get anything. Some types of preferred shares can be converted into common shares.
On the balance sheet, stock is treated a little differently than on the income state- ment because you need more details than just the type and amount of stock for the owners’ equity portion to be useful. In addition to the exact type of stock (in terms of preferred shares, standard preferred or convertible preferred), the balance sheet must also list the percentage dividends guaranteed on preferred stock, the number of shares authorized, and the par value guaranteed to preferred shares in case of liquidation (see the section “Additional paid-in capital” for details on par value).
Common shares
Like preferred shares, common shares give their holders the right to receive divi- dends and obtain company information upon request, but unlike preferred shares, common shares also come with voting rights that can influence company policy. The balance sheet treats common shares similarly to how it treats preferred shares in that the common shares section must list the number of shares outstanding, the number of shares authorized, and their par value.
Treasury shares
Treasury shares are shares of common stock that the issuing company has repur- chased (a common behavior when a company believes the share price of the stock will increase with decreased shares available to investors). Companies often hold on to treasury shares in an attempt to drive up their own share price with the goal of reselling the shares at a profit. Companies aren’t required to list as much infor- mation about these shares on the balance sheet, but they do have to include total value of shares.
Additional paid-in capital
The par value of a stock is originally set by corporations with contributions by their investment bankers at the initial public offering (the first time a specific stock is sold to investors as a company raises money) — often just called the IPO. The investment bankers determine the value of the company, which is used to estab- lish the amount to be raised, and then divide that amount by the total number of shares to get the par value. During the IPO, shares are sold at no less than the par value, but investors often pay more as they try to outbid other investors. Any
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amount that the company raises over par value contributes to the additional paid- in capital and shows up on the balance sheet as such.
Retained earnings
When a company earns income, that is to say when it makes money, that money either goes to the owner(s) of the company or is reinvested in the company. In either case, the money belongs to the company’s owner(s) and must contribute to the value of their ownership in the company. For corporations, any money that doesn’t go to the stockholders in the form of dividends (which are reported on the income statement; see Chapter 5) is reinvested in the value of the company as retained earnings. Retained earnings consist of the money that a company makes after all expenses that it reinvests instead of giving to the stockholders.
Sometimes actions occur that impact the reported value of a company or some portion of the balance sheet. If these actions need more explanation to be fully understood, the company can include them in the supplemental notes portion of the balance sheet at the very bottom.
Finding Financial Zen
The information included in the balance sheet allows you to determine the very value of a company, as well as to whom that value is allocated as the company either thrives or fails in its pursuits. Everything that contributes to the value of a single corporation is either provided by the owners (the shareholders) or the lenders (who the corporation is obligated to repay). It is for this reason that those in corporate finance must work hard to find the appropriate balance between the two (discussed in more detail in Chapter 17).
By applying this information, you can determine a company’s ability to pay back loans, the value of the company’s stock, and the expected return for investors. Plus, you can use the values you get from these metrics to evaluate whether the company is worth any loans issued, how efficiently management is allocating resources, how efficient the company’s production is working, how effective a company is at managing inventory, how efficiently it sells its products, how effec- tive it is at collecting debt, and so much more.
By itself, the balance sheet shows only metrics related to value. But when you use it with information from the income statement and the statement of cash flows, you can determine how effectively a company is using its assets to generate income, as well as how well a company may use income to pay its debts.
A reduction in cash isn’t necessarily a bad thing, as long as the operations are positively contributing to the company’s overall value. If a company is experienc- ing negative cash flows consistently, however, that company’s management has to be careful to ensure they carefully manage the company’s cash and other assets so they can continue to pay their bills.
Reaching Your Destination
The statement of cash flows is a big deal for lenders who are considering whether to give loans to a company. Even if a company is making money, lenders want to make sure the company will have the cash available to make payments on their loans. So, lenders commonly use the statement of cash flows to assess a compa- ny’s financial health, particularly its ability to maintain consistent positive cash flows to the degree required to pay off any potential new loans.
Lenders, managers, and investors frequently use data from the statement of cash flows in metrics to do the following:
» Measure a company’s liquidity (the ability of the company to pay its debts and bills)
» Measure the strength of a company’s profitability
» Evaluate a company’s operational asset management
» Evaluate a company’s financial management regarding the company’s costs of capital
I cover these and other metrics in detail in Chapters 7 and 8.
When comparing data from the statement of cash flows for the same company over a period of years, you can evaluate effective cash management and track the sources of cash flows for the use of financial efficiency and asset utilization optimization.