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4.1 Income Statement

PLEASE NOTE: This book is currently in draft form; material is not final.

Learning Objectives

  1. Describe what an income statement is.
  2. Explain how to read an income statement.
  3. Describe what factors influence the income statement.

The first financial statement we examine is the income statement. An income statement includes revenues earned, expenses paid, and the bottom line to the investors: net income. The income statement is like a movie: it provides a financial film of a firm over a period of time. It is a moving picture of the firm’s financial performance during a given time period, typically a year, but monthly and quarterly financial statements are also prepared. And, while the calendar year ends December 31, companies often pick other dates as their fiscal year end, depending on their industry or selling cycle.

The first line (top line) of an income statement is revenueIncome or the amount of money received by a company during a specific period. (also called sales revenue or sales). This is the total dollar amount of goods and services sold during the given time period. From this, direct expenses incurred to make the good are deducted as cost of goods sold (COGS)Direct costs attributable to the production of goods or services including raw materials and labor.. This results in gross profitThe total amount of profit. The difference between revenue and costs before accounting for other items such as interest, depreciation, taxes and amortization., also known as Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA). Gross profit is what the company made by making and selling its product. From gross profit we need to pay operating, financial (interest) and tax expenses. Operating expensesExpenditures that result from normal business operations. include selling, general and administrative expenses (SG&A), lease expenses, depreciation and amortization and are the typical cost of doing business. While fixed assets aren’t directly “used up” over time, a machine or building will wear out over time and eventually need to be replaced. DepreciationA way to allocate the cost of an asset over its useful life. and amortizationPaying off a debt in regular installments over time. are annual charges that reflect the legal portion of costs of the assets allowed to be deducted. Depreciation relates to tangible assets such as machines and amortization relates to intangible assets such as patents.

Once we subtract the operating expenses from gross profit our result is earnings before interest and taxes (EBIT)A company’s profitability as calculated by revenues minus expenses, excluding tax and interest.. EBIT shows us the firm’s ability to generate cash flow. From EBIT we subtract factors from outside the firm’s operations such as taxes and interest charges. Subtracting interest leaves net profit before taxesRevenues minus all expenses except taxes. also known as Earnings Before Taxes (EBT). Finally we must pay the tax man. After taxes are taken out then net incomeA company’s total profit calculated by revenue minus expenses, depreciation, interest and taxes. (or profitThe financial gain when revenue exceeds costs.) is left. A pro-forma income statement is shown in Figure 4.1 "Pro-Forma Income Statement".

Figure 4.1 Pro-Forma Income Statement

Depreciation and Taxes

Is depreciation a good or bad thing for companies? When equipment or property that will be used over time for operations is purchased, the company is typically not allowed to count the purchase as an expense. If it was allowed, then they EBT would be lower by the cost, and thus taxes due would be lower. Instead, the government makes companies “write down” then machine over time (under the “matching principle” of accounting), which leads to the tax reduction being spread out over time as well. From one point of view, depreciation is nothing more than a legally mandated loan to the government: the tax effect spread out over time instead of taken in the year the fixed asset was purchased!

Key Takeaways

  • Income statements provide a moving picture of a company’s financial position over a period of time.
  • An income statement includes revenues earned and expenses paid and the bottom line to the investors: net income.

Exercises

  1. Review the following 10-K statements

    1. Here is a link to Nike’s 10-K.

      http://nike.q4cdn.com/25140a27-0622-47e1-9f85-99892a766984.pdf?noexit=true

      Look at the Income Statement on page 56. Can you identify revenues? Net income?

    2. Here is a link to Starbuck’s 2011 10-K.

      http://investor.starbucks.com/phoenix.zhtml?c=99518&p=irol -SECText&TEXT=aHR0cDovL2lyLmludC53ZXN0bGF3YnVzaW5lc3MuY29tL2RvY3VtZW50L3YxLzAwMDExOTMxMjUtMTEtMzE3MTc1L3htbA%3d%3d

      Look at the Income Statement on page 43. Can you identify Net Income? Sales revenue? Taxes?

  2. Using this data below, construct an income statement.

    Last year Sun Skateboards had $200,000 in revenues. The company had $70,000 in COGS and $30,000 is SG&A. It was in the 40% corporate tax rate. They had depreciation expense of $35,000 and interest expense of $20,000.