Reporting and Analyzing the Income Statement



Preparation of the Income Statement

An income statement includes detail on operating and non-operating activities.

Learning Objectives

Explain the difference between the operating and non-operating section of the income statement

Key Takeaways

Key Points

  • Cash inflows or other enhancements of assets of an entity during a period from delivering or producing goods, rendering services, or other activities that constitute the entity’s ongoing major operations fall under the revenue category of the income statement.
  • Cash outflows or other using up of assets or incurrence of liabilities during a period from delivering or producing goods, rendering services, or carrying out other activities that constitute the entity’s ongoing major operations appear under the expenses section of the income statement.
  • Discontinued operations is the most common type of irregular items. Shifting business location(s), stopping production temporarily, or changes due to technological improvement do not qualify as discontinued operations. Discontinued operations must be shown separately.
  • Certain items must be disclosed separately in the notes, if material, including write-downs of inventories to net realizable value or of property, and restructuring of the activities of an entity and reversal of any provisions for the costs of restructuring; and more.

Key Terms

  • revenue: Income that a company receives from its normal business activities, usually from the sale of goods and services to customers.
  • expense: In accounting, an expense is money spent or costs incurred in an businesses efforts to generate revenue
  • disclosure: The act of revealing something.

Income Statement

An income statement is a company’s financial statement that indicates how the revenue (money received from the sale of products and services before expenses are taken out, also known as the “top line”) is transformed into the net income (the result after all revenues and expenses have been accounted for, also known as net profit or the “bottom line”). It displays the revenues recognized for a specific period, and the cost and expenses charged against these revenues, including write-offs (e.g., depreciation and amortization of various assets) and taxes. The purpose of the income statement is to show managers and investors whether the company made or lost money during the period being reported.

Operating section

Revenue

Cash inflows or other enhancements of assets of an entity during a period from delivering or producing goods, rendering services, or other activities constitute the entity’s ongoing major operations. It is usually presented as sales minus sales discounts, returns, and allowances. Every time a business sells a product or performs a service, it obtains revenue. This often is referred to as gross revenue or sales revenue.

A Sample Income Statement: Expenses are listed on a company’s income statement.

Expenses

Cash outflows or other using-up of assets or incurrence of liabilities during a period from delivering or producing goods, rendering services, or carrying out other activities constitute the entity’s ongoing major operations.

  • Cost of Goods Sold (COGS)/Cost of Sales represents the direct costs attributable to goods produced and sold by a business (manufacturing or merchandising). It includes material costs, direct labor, and overhead costs (as in absorption costing), and excludes operating costs (period costs), such as selling, administrative, advertising or R&D, etc.
  • Selling, General, and Administrative expenses (SG&A or SGA) consist of the combined payroll costs. SGA is usually understood as a major portion of non-production related costs, in contrast to production costs, such as direct labor. Selling expenses represent expenses needed to sell products (e.g., salaries of sales people, commissions and travel expenses, advertising, freight, shipping, depreciation of sales store buildings and equipment, etc.). General and Administrative (G&A) expenses represent expenses to manage the business (salaries of officers/executives, legal and professional fees, utilities, insurance, depreciation of office building and equipment, office rents, office supplies, etc.).
  • Depreciation / Amortization is the charge with respect to fixed assets/intangible assets that have been capitalized on the balance sheet for a specific (accounting) period. It is a systematic and rational allocation of cost rather than the recognition of market value decrement.
  • Research & Development (R&D) expenses represent expenses included in research and development.

Non-operating Section

  • Other revenues or gains include those from other than primary business activities (e.g., rent, income from patents). They also includes unusual gains that are either unusual or infrequent, but not both (e.g., gains from the sale of securities or gain from disposal of fixed assets)
  • Other expenses or losses not related to primary business operations (e.g., foreign exchange loss).
  • Finance costs are costs of borrowing from various creditors (e.g., interest expenses, bank charges).
  • Income tax expense is the sum of the amount of tax payable to tax authorities in the current reporting period (current tax liabilities/ tax payable) and the amount of deferred tax liabilities (or assets).

Irregular Items

Discontinued operations is the most common type of irregular items. Shifting business location(s), stopping production temporarily, or changes due to technological improvement do not qualify as discontinued operations. Discontinued operations must be shown separately.Disclosures

Certain items must be disclosed separately in the notes (or the statement of comprehensive income), if material, including:

  • Write-downs of inventories to net realizable value or of property, plant and equipment to recoverable amount, as well as reversals of such write-downs
  • Restructurings of the activities of an entity and reversals of any provisions for the costs of restructuring
  • Disposals of items of property, plant, and equipment
  • Disposals of investments
  • Discontinued operations
  • Litigation settlements
  • Other reversals of provisions

Earnings Per Share

Because of its importance, earnings per share (EPS) are required to be disclosed on the face of the income statement. A company that reports any of the irregular items must also report EPS for these items either in the statement or in the notes. There are two forms of EPS reported:

Basic:In this case “weighted average of shares outstanding” includes only actual stocks outstanding.

Diluted: In this case, “weighted average of shares outstanding” is calculated as if all stock options, warrants, convertible bonds, and other securities that could be transformed into shares are transformed. This increases the number of shares and so EPS decreases. Diluted EPS is considered to be a more reliable way to measure EPS.

Income Statement Analyses

The income statement indicates how the revenue is transformed into net income and can provide many insights to a company’s performance.

Learning Objectives

Explain how the different formulas are used on the income statement to show a company’s performance

Key Takeaways

Key Points

  • Net income is an entity’s income minus expenses for an accounting period. It is computed as the residual of all revenues and gains over all expenses and losses for the period. It has also been defined as the net increase in stockholder’s equity that results from a company’s operations.
  • In stock trading, the P/E ratio (price-to- earnings ratio) of a share (also called its “P/E,” or simply “multiple”) is the market price of that share divided by the annual Earnings per Share (EPS). The P/E ratio is a widely used valuation multiple used as a guide to the relative values of companies.
  • The dividend yield or the dividend-price ratio of a share is the company’s total annual dividend payments divided by its market capitalization, or the dividend per share, divided by the price per share.
  • The operating ratio is a financial term defined as a company’s operating expenses as a percentage of revenue. This financial ratio is most commonly used for industries that require a large percentage of revenues to maintain operations, such as railroads.
  • Times interest earned (TIE) or interest coverage ratio is a measure of a company’s ability to honor its debt payments.

Key Terms

  • ratio: A number representing a comparison between two things.
  • revenue: Income that a company receives from its normal business activities, usually from the sale of goods and services to customers.
  • net income: Gross profit minus operating expenses and taxes.

The Income Statement

Income statement (also referred to as profit and loss statement (P&L), revenue statement, statement of financial performance, earnings statement, operating statement or statement of operations) is a company’s financial statement that indicates how the revenue (money received from the sale of products and services before expenses are taken out, also known as the “top line”) is transformed into the net income (the result after all revenues and expenses have been accounted for, also known as Net Profit or the “bottom line”). It displays the revenues recognized for a specific period, and the cost and expenses charged against these revenues, including write-offs (e.g., depreciation and amortization of various assets) and taxes. The purpose of the income statement is to show managers and investors whether the company made or lost money during the period being reported.

A Sample Income Statement: Expenses are listed on a company’s income statement.

The important thing to remember about an income statement is that it represents a period of time. This contrasts with the balance sheet, which represents a single moment in time.

Basic Equations

Revenues – Expenses = Net Income

  • In business, net income also referred to as the bottom line, net profit, or net earnings is an entity’s income minus expenses for an accounting period. It is computed as the residual of all revenues and gains over all expenses and losses for the period. It has also been defined as the net increase in stockholder’s equity that results from a company’s operations.

Earnings per Share = (Net Income – PreferredĀ Dividends) / Shares of Stock Outstanding

  • Earnings per share (EPS) is the amount of earnings per each outstanding share of a company’s stock.

Price to Earnings Ratio = Market Value of Stock / Earnings per Share

  • In stock trading, the P/E ratio (price-to-earnings ratio) of a share (also called its “P/E,” or simply “multiple”) is the market price of that share divided by the annual Earnings per Share (EPS). The P/E ratio is a widely used valuation multiple used as a guide to the relative values of companies. A higher P/E ratio means that investors are paying more for each unit of current net income, so the stock is more “expensive” than one with a lower P/E ratio. The P/E ratio can be regarded as being expressed in years. The price is in currency per share, while earnings are in currency per share per year, so the P/E ratio shows the number of years of earnings which would be required to pay back the purchase price, ignoring inflation, earnings growth and the time value of money.

Dividend Yield = (Dividends per Share / Market Value of Stock) x 100

  • The dividend yield or the dividend-price ratio of a share is the company’s total annual dividend payments divided by its market capitalization, or the dividend per share, divided by the price per share. It is often expressed as a percentage.
  • Dividend yield is used to calculate the earnings on investment (shares) considering only the returns in the form of total dividends declared by the company during the year.

Operating Expense Ratio = Operating Expense / Net Sales

  • The operating ratio is a financial term defined as a company’s operating expenses as a percentage of revenue. This financial ratio is most commonly used for industries that require a large percentage of revenues to maintain operations, such as railroads. In railroading, an operating ratio of 80 or lower is considered desirable.
  • The operating ratio can be used to determine the efficiency of a company’s management by comparing operating expenses to net sales. It is calculated by dividing the operating expenses by the net sales. The smaller the ratio, the greater the organization’s ability to generate profit should revenues decrease. The ratio does not factor in expansion or debt repayment.

Times Interest Earned = Net Income / Annual Interest Expense

  • Times interest earned (TIE) or interest coverage ratio is a measure of a company’s ability to honor its debt payments. It may be calculated as either EBIT or EBITDA divided by the total interest payable.