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The ABCs of Understanding Financial Statements (Part 3 of 4) - Statement of Income - Jul 14, 2010

Posted by: Stu Lipkin in Articles

As discussed in the first of the 4 articles (The ABC's of Understanding Financial Statements-Part 1 of 4), there are always three main components to every financial statement. They are:

Balance Sheet
Statement of Income
Statement of Cash Flows

This article will focus on the Statement of Income or Profit & Loss Statement (aka P & L). Article 4 will address the Statement of Cash Flows.

As discussed in my previous article about the Balance Sheet (The ABC’s of Understanding Financial Statements (Part 2 of 4) - Battling the Balance Sheet), it represents the financial condition as of a specific point in time (i.e. as of December 31). The P & L on the other hand will measure activity for a range of time such as a month, a quarter or a year.

There are some basic concepts the reader needs to understand about the P & L statement.

Recognized Revenues
Cost of Goods Sold (COGS)
Operating Expenses
Depreciation

1. Revenue Recognition

Revenues must be recognized when they are realized (or realizable) and are earned. This identifies when the revenue will be recorded in the P & L. For small companies that record their accounting on the cash basis, revenue is recognized when they collect the money. Unfortunately, the collection period will often be different from the period in which they incur costs required to make that sale. In other words, revenues and related costs may not be reported within the same period of time and will make the P & L have dramatic profits or losses depending on when the actual transactions have been recorded. That is why the accrual method of accounting (please read Part 1 of 4 above for more information on cash vs. accrual accounting) is more accurate when examining the financial results of a company. It more accurately reflects the matching of the revenues and the related costs to generate those revenues. In certain situations, a company may invoice the customer for future services. In those cases, the revenue will not be recognized until the services have actually been performed. The amount of the invoice will be “deferred” and will appear on the balance sheet until such time as the service(s) can be recognized as performed.

For example:

A software company sells a copy of its software (actually a license to use it in perpetuity) and an associated annual maintenance contract.
The revenue attributable to the sale of the license is recognized upon invoicing.
The revenue for the maintenance contract is deferred.
Each month, 1/12^th of the price of the maintenance contract is subtracted from deferred revenue on the Balance Sheet and recognized as revenue on the Income Statement.

Recognition of revenue is from four basic types of transactions:

1) Revenues from selling inventory are recognized at the date of sale, usually the date of delivery.

2) Revenues from rendering services are recognized when services have been performed. In certain situations where the service extends for a long period of time (i.e. construction projects), revenue will be recognized incrementally over the life of that project.

3) Revenue from permission to use company’s assets (e.g. interest for using money, rent for using fixed assets, and royalties for using intangible assets) is recognized as time passes or as assets are used.

4) Revenue from selling an asset other than inventory is recognized at the point of sale when it takes place.

2. Cost of Goods Sold (COGS)

COGS are all expenses directly related to the making and storing of the company’s goods:

Materials used in the manufacturing or direct processing of the product or service.
Labor directly related to the product or service
Other costs incurred which are directly related to the product or service.

Note: Service businesses may not have this category.

3. Operating Expenses

Generally, operating expenses are those costs NOT DIRECTLY related to the processing of the product or service as defined above in COGS. However, these costs are related to the daily operations of the business in general. Typically, interest and income tax expenses are not considered operating expenses and will be reflected in a separate section below Operating Expenses, but above the Net Income of the business.

4. Depreciation

The cost of an asset is not fully expensed in the first year from its purchase, but is spread over the years of its useful life.

This “matches” the expense to the associated revenues over the life of the asset and accounts for the reduction in value of the asset over time.

Example: Computers have a “useful life,” as defined by Generally Accepted Accounting Principles and the IRS Code, of three years. A company will book depreciation of 1/36 of the cost of the computer each month until it is fully depreciated. While the computer may be used by the company for a longer period of time, it is the “useful life” definition that will determine the period for depreciation and not the amount of time actually used by the business.

FAQS

Q: Does every sale result in immediate revenue?
A: Not necessarily! Revenue recognition rules in some businesses, e.g. software, are complex and will be dictated by the specifics or each sale or contract.

Q: If the Income Statement shows a profit, is my company healthy?
A: Not necessarily. While profit is a good thing, the Balance Sheet may show that the company is insolvent (liabilities exceed assets) or cash flow may be negative due to a host of other factors.

Q: If the Income Statement shows a loss, is my company doomed?
A: Not necessarily. While a loss is a serious issue, the company may be implementing a strategy resulting in short term losses for long term gain.

Q: If the most recent Income Statement shows a profit, is my company healthy?
A: Not necessarily. In addition to analyzing the details of that statement, you should be analyzing changes over time and projecting results into the future.

Definition of Key Terms when Analyzing a Statement of Income

Operating Margin = Net Income before Tax, also known as Operating Income, as a % of Revenues/Sales.
EBITDA = Earnings Before Income Taxes, Depreciation and Amortization (see below). Often used in conjunction with a “multiple of earnings” to measure the value of a business or business unit. EBITDA x multiple = business value.
Amortization = the expensing of intangible assets over time (similar to depreciation for tangible assets).

While the P & L is an important scorecard of a company’s direction, it should never be reviewed by itself. Combined with the Balance Sheet and Statement of Cash Flows, you will be able to get a complete of the company’s financial condition.