Investment Basics - Course 301 - The Income Statement

By: Steve Bauer | Wed, Dec 15, 2010
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This is the sixteenth Course in a series of 38 called "Investment Basics" - created by Professor Steven Bauer, a retired university professor and still active asset manager and consultant / mentor.


 

Course 301 - The Income Statement

Introduction

Though learning basic accounting may not be the most enjoyable exercise, knowing how to interpret a company's financial statements is critical to understanding how a business is performing as well as figuring out if a stock is a good value.

In Course 107, I gave a basic introduction to financial statements / accounting. In this Course, we will dig deeper and devote a session to each of the three main financial statements: the income statement, the balance sheet, and the statement of cash flows. Courses 304 and 305 will help you use each of these statements to get a picture of a company's financial health and performance.

First up is the income statement, which summarizes how the company's operations performed during a given period. It tells you how much money a company has brought in (its revenues), how much it has spent (its expenses), and the difference between the two (its profit). Did the company make a profit during the period? Did it improve its business over last year? The income statement will provide you with this information, and more.

Next, we will walk through the different components of the income statement and illustrate how they may vary across different companies. By the end of the session, you should have a grasp of how to read an income statement, and you'll be able to test your knowledge by answering questions using a fictional company's income statement.

Prof's. Guidance: I feel that I must do my best to ask you to grind your way through all this "accounting stuff" - if only to smile and say: " I did it." Please!


Revenue

While income statements for companies in different industries may not look exactly the same, almost all of them begin with the company's revenue for the period. Revenue, which is sometimes called "sales," represents the amount of money a company brings in for selling its goods or services. (Because banks and some other financial institutions make money from interest -- i.e., they don't really "sell" anything -- their income statements look different.)

Depending on the nature of a company's revenue stream, a company will record revenue in one of several ways. When you buy a DVD from Best Buy (BBY), for example, Best Buy recognizes revenue when you give the company your money or your credit card and walk out with your purchase. As another example, an insurance company will "recognize," or earn and record, revenue from premiums that you pay gradually over the period in which you are covered. Be sure to check out a company's "revenue recognition policy," which can be found in the notes accompanying its financial statements, to see how it accounts for its revenue.


Expenses

A company needs to spend money to make money, and these outflows from making and selling its products or providing and selling its services represent a company's expenses. Companies' expenses are usually grouped into similar categories.

Cost of Sales. Cost of sales (also known as cost of goods sold - COGS -- or cost of services) represents all of the expenses directly incurred in creating the goods or services that a company sells. Examples include raw materials, items purchased for resale, the cost of running a factory, and labor. If it cost Best Buy $9 to acquire the DVD that you purchased, that $9 is considered a cost of sales. The steel and rubber Harley-Davidson HOG had to purchase to make its motorcycles would also be grouped into cost of sales.

Selling, General, and Administrative Expenses. Selling, general, and administrative expenses (also known as "SG&A") consist of several types of costs. Selling expenses are those expenses incurred in attempting to create sales for the company. Examples include marketing expenses and compensation for sales staff. General and administrative expenses, meanwhile, represent most overhead costs of operating a company's business. Costs related to a company's human resources and finance departments and costs related to its office buildings are examples of general and administrative expenses.

Depreciation and Amortization. When a company purchases an asset that the company intends to use over a period of time, such as a piece of factory equipment or a building, the asset's entire cost isn't immediately expensed on the income statement. Instead, the company expenses the asset gradually over the estimated useful life of the asset. This expense represents the building's or equipment's normal wear and tear over time, and is referred to as depreciation expense.

Amortization is similar to depreciation, except amortization relates to intangible assets, or assets that do not have a physical presence, such as a brand name. Oftentimes, depreciation and amortization are already included in the other expenses mentioned above, so you may not see them listed separately on the income statement. However, the statement of cash flows, one of the other key financial statements, has depreciation and amortization amounts (sometimes combined) disclosed.

It is worth noting that depreciation and amortization expenses are non cash expenses. For more information about non cash revenue and expenses, read the section on accrual accounting later in this session.

Other Operating Expenses. Other operating expenses represent all other expenses related to a company's primary operations not included in the above categories. Often, nonrecurring costs or accounting gains are included here. Pay close attention to these items. Some companies abuse these "one-time" accounting events to the point where they become annual events. Also, they frequently include items such as restructuring charges, which are costs incurred to close a factory or lay off part of the workforce, for example. They may also include asset write-offs or write-downs, which often suggest that management may have paid too much for a particular asset or invested too much in an unprofitable business.

Interest Income and Interest Expense. In order to raise funds for the purchase of assets used to run the business, a company may issue debt (i.e., borrow money). In most cases, the company is required to pay interest on these obligations. Conversely, when a company has more cash than it currently needs for operating its business, it may invest this excess money. These investments often earn interest or investment income. On the income statement, you may see interest expense and interest income listed separately or lumped together as net interest expense or net interest income.

Taxes. Just as you pay taxes to Uncle Sam, most companies do, too. For companies that make a profit, taxes are an expense on the income statement.


Important Income Statement Calculations

Now that we've talked about some of the major line items found on the income statement, let's discuss some of the important figures that are already calculated for us on it.

Gross Profit. You actually won't find this amount on all income statements, but it is very easy for you to calculate yourself. Just take revenue and subtract cost of sales. Gross profit shows how much of a markup a company receives on the goods and services it sells. If you paid $12 for a DVD at Best Buy, and Best Buy's acquisition cost was $9, the gross profit Best Buy realizes is $3, or 25% of the sales price.

Operating Income. Arguably the best indicator of a company's true performance, operating income is often called operating profit. It is calculated by subtracting cost of sales and all operating expenses (SG&A, depreciation, amortization, restructuring, and other operating expenses) from total revenue. Operating income measures the profit (or, in the case of poorly performing companies, the loss) that a company is able to generate through its main operations. Operating income is also sometimes called "earnings before interest and taxes" (EBIT) because those expenses are not considered "operating" expenses.

Net Income. Net income is what's left over for a company after all expenses have been accounted for. It is sometimes referred to as a company's "bottom line." Many management teams and Wall Street analysts talk quite a bit about net income, but keep in mind that many types of items, such as one-time gains, can distort this figure. It is generally a poor proxy for a company's cash flow. And though net income is important, it should not be thought of as the end-all, be-all figure to focus on.

Earnings Per Share. Earnings per share, or "EPS," is simply net income divided by the weighted average number of shares outstanding during the relevant period. (This number of shares is also listed on the income statement.) EPS is what management and Wall Street analysts seem to focus on most, since it is the profit left over for stockholders. While EPS can be a useful number, be sure to consider it in context with the company's other financial information.

You'll notice that two EPS calculations are performed on the income statement: one for basic EPS and the other for diluted EPS. The difference is in the way the number of shares outstanding is used. The basic EPS calculation uses basic shares, which are the actual shares of a company's stock outstanding, as its denominator.

Conversely, the diluted EPS calculation uses diluted shares outstanding, which takes into account securities that could be converted into common stock at some future point. Such securities include stock options issued to employees and convertible bonds. Using diluted shares is much more informative than using basic shares, because if and when these securities are converted into shares of common stock, your stake in the company, or your piece of the total pie, gets smaller and smaller.


Accrual Accounting

Chances are, at some point in your life you've subscribed to a newspaper or magazine. Most likely, the newspaper or magazine publisher asked you to pay for the cost of the entire year's worth of issues at the beginning of your subscription. However, when the publisher received your up-front payment, it was not allowed to record the entire amount of cash that you paid it as revenue.

The above occurrence highlights the concept of accrual accounting, the accounting method used in the United States by publicly traded companies. Accrual accounting attempts to recognize revenue and expenses in the specific period in which they occur. For instance, accrual accounting recognizes revenue in the period in which the company sells its goods or actually provides its services. In our newspaper subscription example, the publisher recognizes revenue from your subscription gradually over the length of the subscription. So, in effect, the publisher is still recognizing revenue from your subscription weeks and even months after receiving your payment.

Accrual accounting is also applied to reflect the purchase and use of a large piece of equipment or a building. When a company purchases such an asset, it does not record the entire cost of the asset as an up-front expense that runs through the income statement. Rather, it records the purchase price of the asset on the balance sheet. Then, each year, it takes a portion of that asset's cost and expenses it on the income statement as a depreciation expense.

Depreciation expense, which represents normal wear and tear for an asset (much as your car depreciates a little each year), reduces the recorded book value of the asset every year (very similar to how the value of your car goes down the longer you keep it). Keep in mind that depreciation is a non cash expense because the cash outlay already occurred when the asset was purchased and recorded on the balance sheet.

Accrual accounting allows revenue and expenses to be recognized in the appropriate periods, letting a company match as best it can its sales with the expenses incurred in generating those sales. As you can see, cash in the door does not always mean immediate revenue for a company, and cash out the door does not always mean immediate expense for a company, either. Keep this important concept in mind as you analyze any company's income statement.


The Bottom Line

With this Course, we've laid the foundation for how to interpret the numbers on an income statement to assess a company's performance and profitability. There is a lot of information in this lesson, so do not be afraid to read it more than once in order to absorb all the concepts. With the ability to analyze an income statement, you should get some sense as to how profitable a company actually is, a key consideration in deciding whether or not to become an owner in that company.

Quiz 301
There is only one correct answer to each question.

  1. A company's sales, minus its cost of sales, is known as:
    1. Revenue.
    2. Gross profit.
    3. Net income.
  1. Which of the following best measures the results of a company's primary business?
    1. Gross profit.
    2. Operating income.
    3. Net income.
  1. Under accrual accounting, a company recognizes revenue when:
    1. A customer delivers cash payment.
    2. The company receives cash payment.
    3. The company has earned it.
  1. Under accrual accounting, a company records an expense when:
    1. The company delivers cash payment to a supplier.
    2. The supplier receives cash payment from a company.
    3. The company has incurred it.
  1. Which of the following expenses is subtracted from sales when calculating operating profit?
    1. Interest.
    2. SG&A.
    3. Taxes.

Thanks for attending class this week - and - don't put off doing some extra homework (using Google - for information and answers to your questions) and perhaps sharing with the Prof. your questions and concerns.

 


Investment Basics (a 38 Week - Comprehensive Course)
By: Professor Steven Bauer

Text: Google has the answers to most all of your questions, after exploring Google if you still have thoughts or questions my Email is open 24/7.

Each week you will receive your Course Materials. There will be two kinds of highlights: a) Prof's Guidance, and b) Italic within the text material. You should consider printing the Course Materials and making notes of those areas of questions and perhaps the highlights and go to Google to see what is available to supplement those highlights. I'm here to help.

Freshman Year

Course 101 - Stock Versus Other Investments
Course 102 - The Magic of Compounding
Course 103 - Investing for the Long Run
Course 104 - What Matters & What Doesn't
Course 105 - The Purpose of a Company
Course 106 - Gathering Information
Course 107 - Introduction to Financial Statements
Course 108 - Learn the Lingo & Some Basic Ratios

Sophomore Year

Course 201 - Stocks & Taxes
Course 202 - Using Financial Services Wisely
Course 203 - Understanding the News
Course 204 - Start Thinking Like an Analyst
Course 205 - Economic Moats
Course 206 - More on Competitive Positioning
Course 207 - Weighting Management Quality

Junor Year

Course 301 - The Income Statement
Course 302 - The Balance Sheet
Course 303 - The Statement of Cash Flows
Course 304 - Interpreting the Numbers
Course 305 - Quantifying Competitive Advantages

Senor Year

Course 401 - Understanding Value
Course 402 - Using Ratios and Multiples
Course 403 - Introduction to Discounted Cash Flow
Course 404 - Putting OCF into Action
Course 405 - The Fat-Pitch Strategy
Course 406 - Using Morningstar as a Reference
Course 407 - Psychology and Investing
Course 408 - The Case for Dividends
Course 409 - The Dividend Drill

Graduate School

Course 501 - Constructing a Portfolio
Course 502 - Introduction to Options
Course 503 - Unconventional Equities
Course 504 - Wise Analysts: Benjamin Graham
Course 505 - Wise Analysts: Philip Fisher
Course 506 - Wise Analysts: Warren Buffett
Course 507 - Wise Analysts: Peter Lynch
Course 508 - Wise Analysts: Others
Course 509 - 20 Stock & Investing Tips

This Completes the List of Courses.

Wishing you a wonderful learning experience and the continued desire to grow your knowledge. Education is an essential part of living wisely and the experiences of life, I hope you make it fun.

Learning how to consistently profit in the Stock Market, in good times and in not so good times requires time and unfortunately mistakes which are called losses. Why not be profitable while you are learning? Let me know if I can help.

 


 

Author: Steve Bauer

Steven H. Bauer, Ph.D.

Steve Bauer

Steve has several degrees, i.e. post graduate degrees and doctorate and a great deal of (too much) continued education. For seven years, he did a stent as a University Professor of Finance and Economics.

He owned a privately held asset management firm and managed individual investor and corporate accounts as a Registered Investment Advisor - for over 40 years.

Professionally he is a financial analyst and private asset manager / consultant / mentor.

Steve can be reach at senorstevedrmx@yahoo.com

Copyright © 2010-2011 Steven H. Bauer, Ph.D.

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