Income Statement Review Dr Craig Ruff Department of

Income Statement Review Dr. Craig Ruff Department of Finance J. Mack Robinson College of Business Georgia State University © 2014 Craig Ruff 1

The Basic Income Statement… Revenue minus Expenses Income • The income statement is the accounting statement that matches a company’s revenues with its expenses over a period (typically, a quarter or a year). • It is a flow measure… the cumulative amount over the period. This is in contrast to a stock measure, which looks at things at a given point in time. • Profit does not equal cash flow. Accounting is accrual based. Sales are recorded when made and expenses are recorded when incurred, even if the cash flows from these transactions occur in different periods. © 2014 Craig Ruff 2

Multi-Step Income Statement… Income Statement XYZ Company For the Year Ending December 31, 2013 Net Sales minus Cost of Goods Sold Gross Profit minus Operating Expenses Operating Profit (Operating Income, Earnings Before Interest and Taxes, EBIT) minus Interest Expense Profit Before Taxes (Earnings Before Taxes, EBT) minus Taxes Net Income (Earnings) © 2014 Craig Ruff 3

Multi-Step Income Statement – Slightly Different Version Income Statement XYZ Company For the Year Ending December 31, 2013 This is the same as the statement on the previous slide; however, on this one, depreciation expense is broken out from the operating expenses. Net Sales minus Cost of Goods Sold Gross Profit minus Operating Expenses (excluding Depreciation Expense) minus Depreciation Expense Operating Profit (Operating Income, Earnings Before Interest and Taxes, EBIT) minus Interest Expense Profit Before Taxes (Earnings Before Taxes, EBT) minus Taxes Net Income (Earnings) © 2014 Craig Ruff 4

Multi-Step Income Statement… Income Statement XYZ Company For the Year Ending December 31, 2013 Net Sales = Gross Sales – (Returns and Allowances). The term ‘top line’ refers to a company's gross sales (or revenues). So, for instance, when you hear the term, ‘top-line growth’, this is a reference to an increase in the company’s gross sales (or revenues). Sales Returns happen when a customer returns defective, damaged, or otherwise unwanted products to the seller. Sales allowances happen when a customer agrees to keep damaged, defective or unwanted merchandise in exchange for a reduction in the selling price. © 2014 Craig Ruff 5

Multi-Step Income Statement… Income Statement XYZ Company For the Year Ending December 31, 2013 Net Sales minus Cost of Goods Sold These are the direct costs associated with the manufacture or sale of the product. For a retail company, the COGS is simply the cost of materials purchased for resale. For a manufacturing company, the COGS can also include labor costs, manufacturing overhead, and depreciation expenses associated with production. Unless stated otherwise, we will assume that all firms are retailers and, thus, COGS will simply be the cost of materials purchased for resale. © 2014 Craig Ruff 6

Multi-Step Income Statement… Income Statement XYZ Company For the Year Ending December 31, 2013 The gross profit and the gross profit margin (gross profit/sales) are very important numbers in finance. Net Sales minus Cost of Goods Sold For instance, the gross profit margin provides an indication of how Gross Profit effectively a manufacturing company is managing its production process and its use of outside suppliers. Another interpretation is that the gross profit margin shows the percentage of sales (or revenues) available to cover operating expenses. Additionally, the gross profit margin can often tell you something about a company’s business strategy. © 2014 Craig Ruff 7

Multi-Step Income Statement… Income Statement XYZ Company For the Year Ending December 31, 2013 The operating expenses are the business-related expenses other than cost of goods sold that a company incurs in the normal course of its business. These include advertising expenses, repairs and maintenance costs, research and development costs (R&D), sales, general and administrative costs (SG&A), and Net Sales management salaries. For manufactures, depreciation can be in the COGS; for retailers, depreciation is in the operating minus Cost of Goods Sold expenses. Gross Profit minus Operating Expenses (excluding Depreciation Expense) © 2014 Craig Ruff 8

Multi-Step Income Statement… Depreciation is the accounting process by which a company allocates an asset's cost over its expected useful life. Income Statement XYZ Company For the Year Ending December 31, 2013 Net Sales minus Cost of Goods Sold Gross Profit minus Operating Expenses (excluding Depreciation Expense) minus Depreciation Expense Imagine that a company buys a piece of equipment for $1, 000. Also, assume that the equipment is expected to last for 10 years and have zero salvage value. It would not present an accurate picture to expense the entire $1, 000 in the year that equipment is purchased. Instead the accountants will spread out the cost of the machine by gradually expensing the $1, 000 over the course of the expected 10 -year life of the asset. Again, for manufactures, depreciation can be in the COGS; for retailers, depreciation is in the operating expenses. © 2014 Craig Ruff 9

Multi-Step Income Statement… Like gross profit and the gross profit margin, operating profit and the operating profit margin (operating profits/sales) are important finance variables. Income Statement XYZ Company For the Year Ending December 31, 2013 They serves as an indication of how effectively a company is managing its core business and shows the percentage of sales (or revenues) available to cover interest and payback borrowing. Net Sales Note that operating profit has a variety of names. I tend minus Cost of Goods Sold to use EBIT, because that reminds us what comes next. Gross Profit minus Operating Expenses (excluding Depreciation Expense) minus Depreciation Expense Operating Profit (also called: Operating Income, Earnings Before Interest and Taxes, EBIT) © 2014 Craig Ruff 10

Multi-Step Income Statement… Income Statement XYZ Company For the Year Ending December 31, 2013 Interest expense captures the interest cost of the company’s debt in that period. Net Sales minus Cost of Goods Sold Gross Profit minus Operating Expenses (excluding Depreciation Expense) minus Depreciation Expense Operating Profit (Operating Income, Earnings Before Interest and Taxes, EBIT) minus Interest Expense Profit Before Taxes (Earnings Before Taxes, EBT) © 2014 Craig Ruff 11

Multi-Step Income Statement… Income Statement XYZ Company For the Year Ending December 31, 2013 Taxes reflect income taxes at all levels. (Remember that what the company is actually paying in taxes in a given period is not the same as what the company truly owes…the difference going into deferred taxes. ) Net Sales minus Cost of Goods Sold Gross Profit minus Operating Expenses (excluding Depreciation Expense) minus Depreciation Expense Operating Profit (Operating Income, Earnings Before Interest and Taxes, EBIT) Minus Interest Expense Profit Before Taxes (Earnings Before Taxes, EBT) minus Taxes Net Income (Earnings) © 2014 Craig Ruff 12

Multi-Step Income Statement… Income Statement XYZ Company For the Year Ending December 31, 2013 Net Sales minus Cost of Goods Sold Gross Profit minus Operating Expenses (excluding Depreciation Expense) minus Depreciation Expense Operating Profit (Operating Income, Earnings Before Interest and Taxes, EBIT) Minus Interest Expense Net income is often referred to as the ‘bottom line. ’ It is a standard measure of Profit Before Taxes (Earnings Before Taxes, EBT) the company’s profitability. minus Taxes Net Income (Earnings) © 2014 Craig Ruff 13

Multi-Step Income Statement… Income Statement XYZ Company For the Year Ending December 31, 2013 Net Sales minus Cost of Goods Sold Gross Profit (1) minus Operating Expenses (excluding Depreciation Expense) minus Depreciation Expense Operating Profit (Operating Income, Earnings Before Interest and Taxes, EBIT) (2) Minus Interest Expense Profit Before Taxes (Earnings Before Taxes, EBT) (3) minus Taxes Net Income (Earnings) (4) © 2014 Craig Ruff 14

Multi-Step Income Statement… Income Statement XYZ Company For the Year Ending December 31, 2009 Net Sales minus Cost of Goods Sold Gross Profit minus Operating Expenses Operating Profit (Operating Income, Earnings Before Interest and Taxes, EBIT) Assets Liabilities Equity minus Interest Expense Profit Before Taxes (Earnings Before Taxes, EBT) minus Taxes Net Income (Earnings) © 2014 Craig Ruff 15

Multi-Step Income Statement… Income Statement XYZ Company For the Year Ending December 31, 2009 Net Sales minus Cost of Goods Sold Gross Profit minus Operating Expenses Operating Profit (Operating Income, Earnings Before Interest and Taxes, EBIT) Assets Liabilities Equity Minus Interest Expense Profit Before Taxes (Earnings Before Taxes, EBT) minus Taxes Net Income (Earnings) © 2014 Craig Ruff 16

Multi-Step Income Statement… Income Statement XYZ Company For the Year Ending December 31, 2009 Net Sales minus Cost of Goods Sold Assets Gross Profit minus Operating Expenses Operating Profit (Operating Income, Earnings Before Interest and Taxes, EBIT) Liabilities Equity Minus Interest Expense Profit Before Taxes (Earnings Before Taxes, EBT) minus Taxes Net Income (Earnings) © 2014 Craig Ruff Government 17

Multi-Step Income Statement… Income Statement XYZ Company For the Year Ending December 31, 2009 Net Sales minus Cost of Goods Sold Gross Profit minus Operating Expenses Operating Profit (Operating Income, Earnings Before Interest and Taxes, EBIT) Assets Liabilities Equity Minus Interest Expense Profit Before Taxes (Earnings Before Taxes, EBT) minus Taxes Net Income (Earnings) © 2014 Craig Ruff 18

Multi-Step Income Statement… Income Statement XYZ Company For the Year Ending December 31, 2009 Net Sales minus Cost of Goods Sold Gross Profit minus Operating Expenses Operating Profit (Operating Income, Earnings Before Income and Taxes, EBIT) Minus Interest Expense Profit Before Taxes (Earnings Before Taxes, EBT) Net income can ‘go to’ two places: (1) It is paid out as dividends to shareholders. (2) It is added to (or subtracted from) retained earnings. minus Taxes Net Income (Earnings) © 2014 Craig Ruff 19

Multi-Step Income Statement… …paid out as dividends to firm’s shareholders, or Net Income is either… …added to (or subtracted from) retained earnings. You can think about this as the money is being ‘reinvested’ in the firm, kept as ‘cash’, used to reduce existing debt, etc. Point: there is no retained earnings bank account. © 2014 Craig Ruff 20

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