Chapter 3:
The Income Statement
1
The Income Statement
z
... reports revenues and expenses (performance)
over a period of time
z
... a profit (or loss) affects not only the income
statement but the balance sheet as well
z
Why? Because profits (losses) accrue to the
owners of a company.
Assets
=
Liabilities
+
Owner's Equity
(profits)
(losses)
2
Revenues and Expenses
z
Revenues
Œ
z
gross increase in owner‘s equity resulting from operating the
business with the objective of generating profits
→ usually results in an increase in an asset
• Examples: sales; fees, commissions; interest; dividends; rents
Expenses
Œ
cost of assets consumed or services used resulting from
business activities and are, in general, actual or expected cash
outflows
• Examples: salaries, wages; interest on loans; insurance premiums;
cost of providing fringe benefits to employees; decrease in inventory
Revenues
>
Expenses
Net profit
Revenues
<
Expenses
Net loss
3
Some Terminology
Cash Inflow
Revenue
Cash Outflow
Expense
Do not mix up the terms!
Revenue is not necessarily a cash inflow and
an expense is not necessarily a cash outflow.
4
Angie‘s business story continued
transactions (in chronological order):
6. Invited speech at a regional conference, € 1000, remitted to the
bank account
Œ
7.
First rent and utility payment due, charged to bank account,
€500.
Œ
8.
This is an expense:
Accounts affected: Cost of office space; Bank
Prepayment received for a series of invited speeches, € 4.500.
Œ
9.
This is a revenue:
Accounts affected: Bank; Revenues; Amount: 1.000
This is not yet a revenue, this is unearned revenue
Accounts affected: Bank; Unearned revenue.
Personal expenses (haircut, groceries, etc.), € 400, paid using
the EC card.
Œ
This is a withdrawal
Accounts affected: Owner’s equity; Bank.
5
Other events affecting owner‘s equity
z
Asset values on the balance sheet sometimes change without
any transaction
Œ
Œ
Œ
z
e.g. foreign subsidiaries set up financial statements in the
currency of the host country
the values of their assets show up in consolidated financial
statements of the parent
• so their values have to be translated into the currency of the
parent‘s home country
• some asset items are translated at the current exchange rate
• this changes net assets and, consequently owner‘s equity
these changes in value are not shown in the income statement
(„dirty surplus accounting“), they show up in the statement of
shareholders‘ equity
The statement of shareholders‘ equity shows furthermore the
transactions between the company and its shareholders
Œ
e.g. share issues, the exercise of stock options granted to
management
6
Beginning Stocks
Flows
Ending Stocks
Cash Flow Statement
Cash from operations
Cash from investing
Cash from financing
Net change in cash
Beginning Balance
Sheet
Cash
+ Other assets
Total assets
– Liabilities
Owner‘s equity
Statement of Owner‘s
Equity
Ending Balance Sheet
Investment and disinvestment by owners
Cash
+ Other assets
Total assets
Net income/other
earnings
– Liabilities
Owner‘s equity
Net change in owner‘s
equity
Income Statement
Source: Penman,
Revenues
Expenses
Financial Statement
Analysis, 2nd ed., p.37
Net income
7
Income Statement of the Coca Cola Comp.
The Coca-Cola Company and Subsidiaries
Condensed Consolidated Statements of Incom (UNAUDITED)
(In million $)
NET OPERATING REVENUES
Cost of goods sold
GROSS PROFIT
Year Ended
December 31, 2008
$
31.944
11.374
20.570
Selling, general and administrative expenses
Other operating charges
OPERATING INCOME
11.774
350
8.446
Interest income
Interest expense
Equity income — net
Other loss — net
333
438
-874
-28
INCOME BEFORE INCOME TAXES
7.439
Income taxes
NET INCOME
1.632
5.807
$
8
Income Statement Format
(funcional basis)
Net Revenue
– Cost of goods sold (by product category)
Gross margin
– Operating expenses
Operating Income (EBIT)
+ Financial, Investment & other revenue
– Financial expenses
– expenses from investments and other
Income before Taxes
Cost of
goods sold
Operating
expenses
EBIT
Revenue
– Income taxes
Income after Tax
+ Extraordinary Items
Net income
9
Income Statement Format
(natural basis)
Sales Revenue
+/– Change in product inventory
– Period expenses (by type)
Net income
Period
Expenses
Revenue
Increase in
product
Net Income inventory
10
Explanations of income statement items
z
z
Net revenue = gross revenue
– discounts
– returns
Cost of goods sold = cost of goods available for sale
– ending product inventory
Œ
Cost of goods available for sale = beginning product inventory
+ cost of goods manufactured
ΠCost of goods manufactured = direct materials
+ direct labor
+ allocated production
overhead cost
Πending product inventory (finished and work in process)
value to be determined according to an inventory valuation
method, e.g. LIFO, weighted average cost
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Explanations of income statement items
z
Operating expenses: e.g.
Œ
Marketing expenses,
ΠResearch & Development expenses
ΠGeneral and administrative expenses
z
Investment and other income, e.g.
Œ
Interest revenue – interest expenses
Πdividends received
Πprofit (loss) from selling financial assets
z
Income taxes
Œ
z
calculated from the taxable income of the period, not according
to tax payments!
Extraordinary items: any irregularly occuring items e.g.
Œ
profit or loss from terminating an investment
Πrestructuring charges (e.g. devaluation of assets because of
misinvestment; severance pays, indemnifications)
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Cash Flow Statement
z
z
Proceeds and expenditures are not equal to revenues and expenses,
respectively.
A possible layout:
Œ
Œ
Œ
Œ
Œ
Cash and Cash equivalents, beginning balance
+ Cash Flow from operations
(= net income
+ depreciation and amortization
+ increase in deferred income taxes
+ change in provisions
+ increase in accounts payable and accrued expenses
– increase in accounts receivable
+ decrease in inventories
– increase in prepaid expenses)
+ Cash Flow from Investing Activities
(= Proceeds from sales – investment in of property, plant and equipment
+ net decrease in investments and other assets)
+ Cash Flow from Financing Activities
(= Net proceeds from long term debt – repayments
+ net proceeds from increase in contributed equity)
= Cash and Cash Equivalents, ending balance
13
Ratios
z
z
Return on Equity
Net Profit
RoE = ½ (beginning + ending shareholders‘ equity)
Gross Margin Ratio =
Gross Margin
Sales Revenue
Operating Expenses
Sales Revenue
z
Operating Expense Ratio =
z
Sales Profit Margin = SalesEBIT
= GMR – OER
Revenue
z
Asset turnover =
Sales Revenue
avg. NOA
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Ratios cont‘d
z
Return on Assets
RoA = Operating Profit
Average total assets
z
Borrowing cost
BC = Financial Expense after tax
net debt
z
z
RoE = RoA + (RoA – BC) × debt/equity ratio
(Financial leverage equation)
(decomposition of RoE into driving forces)
Ratios are used for comparisons
Œ
between similar businesses in one period
Πfor the same business between periods
and – if assumed to be stable – for forecasting
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