Understanding
Financial Statements
EIGHTH EDITION
Lyn M. Fraser
Aileen Ormiston
Income Statement and
Statement of Stockholders’ Equity
Learning about earnings, the bottom line,
Is very important most of the time.
A phony number
Just may encumber
Those folks trying to make more than a dime.
--A. Ormiston
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The Income Statement
Also called the Statement of Earnings
Presents:
Revenues
Expenses
Net Income
Earnings Per Share
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The Income Statement
(cont.)
Comes in two basic formats
Multiple-step
Single-step
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The Income Statement
(cont.)
Multiple-step
Provides several intermediate profit
measures prior to the amount of net
earnings for the period:



Gross profit
Operating profit
Earnings before income taxes
Should be used for purposes of analysis
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The Income Statement
(cont.)
Single-step
Groups all items of revenue together,
then deducts all categories of
expense to arrive at a figure for
net income
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The Income Statement
(cont.)
Regardless of format, certain special
items, if they occur during an
accounting period, must be
disclosed separately on an income
statement
These include. . .
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The Income Statement



(cont.)
Discontinued operations
Extraordinary transactions
Cumulative effect of changes in
accounting principles
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Common-Size
Income Statement
Useful analytical tool
Expresses each income statement item
as a percentage of net sales
Shows the relative magnitude of
various expenses relative to sales,
the profit percentages, and the
relative importance of “other”
revenues and expenses
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Common-Size income statement
(cont.)
Comparison of two major retail companies*
Comparison using $ ($ are in millions):
Retailer A
Net Sales
$ 287,989
Cost of Sales
219,793
Operating Expenses
51,105
Net Income
10,267
Retailer B
$ 46,839
31,445
11,793
3,198
*Data from SEC website, www.sec.gov
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Common-Size income statement
(cont.)
Comparison of two major retail companies*
Comparison using common size income statement %:
Net Sales
Cost of Sales
Operating Expenses
Net Income
Retailer A
100.00
76.32
17.75
3.57
Retailer B
100.00
67.13
25.18
6.83
*Data from SEC website, www.sec.gov
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Net Sales
Sales are generally reported net of sales
returns and sales allowances
A sales return is a cancellation of a sale
A sales allowance is a deduction from
the original sales invoice price
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Net Sales—Related Issue
Are sales growing in “real” (inflationadjusted) as well as “nominal”
(as reported) terms?
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Net Sales—Related Issue
(cont.)
An adjustment of the reported sales
figure with the Consumer Price
Index (or some other measure of
general inflation) will enable the
analyst to make a comparison of
the changes in real and nominal
terms
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Cost of Goods Sold (COGS)






Also called “Cost of Sales”
Cost to seller of products or services sold
to customers
Important for profit determination
Largest expense item for many firms
Impacted by cost flow assumption used
to value inventory
Cost of goods sold percentage is:
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Cost of goods sold
Net sales
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Gross Profit




First step of profit measurement
Difference between net sales and COGS
Key analytical tool in assessing a firm’s
operating performance
Gross Profit Margin is:
Gross profit
Net sales
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Understand the Math!
If COGS percentage increases or
decreases, this does not necessarily
mean that costs have increased or
decreased
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Understand the Math!
(cont.)
The change in the percentage may be
caused by decreases or increases in
the selling price
For example. . .
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Understand the Math!
Year 1
(cont.)
Year 2
Sales
$10
100%
$8
100%
COGS
4
40%
4
50%
Gross Profit $ 6
60%
$4
50%
Always pay attention to the numbers—know the
difference between raw dollars and percentages!
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Operating Expense
Have considerable impact on the firm’s
current and future profitability
Important to track carefully--trends,
absolute amounts, relationship to
sales, relationship to industry
competitors
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Operating Expense
(cont.)
Examples:
Selling and administrative
Advertising
Operating lease payments
Depreciation and amortization
Repairs and maintenance
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Depreciation and Amortization
Depreciation
Used to allocate the cost of tangible fixed
assets, other than land, that will benefit a
business for more than a year, such as:
Buildings
Machinery
Equipment
Furniture and Fixtures
Motor Vehicles
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Depreciation and Amortization
(cont.).
Amortization is the allocation process applied to:
Capital leases
Leasehold improvements
Cost expiration of intangible assets
Patents
Copyrights
Trademarks
Licenses
Franchises
Goodwill
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Depreciation and Amortization
(cont.)
The amount of expense recognized in
any accounting period will depend on
 the level of investment in the
relevant asset
 estimates with regard to the asset’s
service life and residual value
 and for depreciation, the method
used
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Operating Profit

Second step of profit
measurement

Also called EBIT—Earnings Before
Interest and Taxes
Measures overall performance of
company’s operations: sales
revenue less expenses associated
with generating sales

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Operating Profit


(cont.)
Provides a basis for assessing the
success of a company apart from its
financing and investing activities and
separate from tax considerations
Operating Profit Margin is:
Operating profit
Net sales
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Other Income (Expense)
Includes
Revenues/expenses other than from operations
Dividend and interest income
Interest expense
Investment gains/losses
Equity earnings/losses
Sales of fixed assets gains/losses
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Equity Earnings
Two methods may be used to account
for investments in voting stock of
other companies of less than 50%
Equity
Cost
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Equity Method
Allows the investor proportionate
recognition of the investee’s net
income, irrespective of the payment
or nonpayment of cash dividends
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Cost Method
Investor recognizes investment income
only to the extent of any cash
dividends received
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Cost vs. Equity
Analysts should be aware of whether a
company uses the cost or the equity
method
Equity method distorts earnings in the
sense that income is recognized
even though no cash may ever be
received
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Earnings Before Income Taxes/
Effective Tax Rate



Earnings before income taxes is the profit
recognized before deduction of income
tax expense
Remember, income taxes paid may differ
from income tax expense
(deferred taxes)
Effective tax rate is:
Income taxes
Earnings before income taxes
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Special Items
Are often one-time items that will not
recur in the future
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Special Items
(cont.)
If companies are affected by the following
three items, they must be disclosed
separately on the income statement, net
of income tax effects or retrospectively
applied to prior periods’ financial
statements:
Discontinued operations
Extraordinary items
Accounting changes
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Discontinued Operations
Occur when a firms sells or discontinues
a clearly distinguishable portion of
its business
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Extraordinary Items
Gains and losses that meet two criteria:
1. Unusual in nature
2. Not expected to recur in the
foreseeable future, considering the
firm’s operating environment
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Accounting Changes


Prior to 2006, the cumulative effect of a
change in accounting principle was
disclosed when a firm changed an
accounting policy
Retrospective application to prior periods’
financial statements is required for
changes in accounting principles for fiscal
years beginning after 12/15/2005 per
SFAS #154, “Accounting Changes and
Error Corrections”
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Net Earnings



Also called the “bottom line”
Represents the firm’s profit after
consideration of ALL revenue and
expense
Net profit margin is:
Net earnings
Net sales
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Earnings Per Common Share
The net earnings available to common
stockholders for the period divided
by the average number of common
stock shares outstanding
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Earnings Per Common Share
(cont.)
If firm has “complex” capital structure, it
will report basic and diluted EPS
Extensively used by analysts in
evaluating a firm
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Earnings Per Common Share
(cont.)
Examples of basic and diluted EPS data reported
by a variety of companies*
Basic EPS
Airline
$ .70
Grain Mill
3.34
Recreation
1.56
Retailer
2.45
Semicond. Mfg.
1.03
Diluted EPS
$ .67
3.08
1.50
2.43
1.01
*Data from SEC website, www.sec.gov
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Comprehensive Income
The change in equity of a company
during a period from transactions,
other events, and circumstances
relating to nonowner sources
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Comprehensive Income
(cont.)
Companies are required to report total
comprehensive income in one of
three ways:
1. On the face of the income statement
2. In the statement of stockholders’
3.
equity
In a separate statement of
comprehensive income
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Comprehensive Income
(cont.)
Currently, there are four items that may
comprise a company’s other
comprehensive income:
1.
2.
3.
4.
Foreign currency translation effects
Unrealized gains and losses
Additional pension liabilities
Cash flow hedges
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The Statement
of Stockholders’ Equity
Details transactions that affected the
balance sheet equity accounts
during an accounting period
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The Statement
of Stockholders’ Equity
(cont.)
Basically, it simply explains how each
account got from the balance at the
beginning of the period to the
balance at the end of the period
and describes “events” that caused
the balances to change
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Earnings Quality, Cash Flow,
Segmental Accounting
Other topics directly related to the income
statement:

Earnings quality – assessment of the quality of


reported earnings is an essential element of
income statement analysis
Cash flow – cash flow from operations is a key
ingredient in analyzing operating performance
Segmental accounting – reviewing the
contribution by each segment of a diversified
company facilitates the analysis of operating
performance
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The Journey
Through the Maze Continues
Ch. 4:
Ch. 5:
Ch. 6:
(C) 2007 Prentice Hall, Inc.
Statement of Cash Flows
A Guide to Earnings and
Financial Reporting Quality
The Analysis of Financial
Statements
3-48