This post is part of the Finance for Non-Financial Managers book series of posts, which is the first subset of posts in the larger PMBA series of posts. You can buy Finance for Non-Financial Managers from the author Gene Siciliano for $14.95.
Summary points for this chapter include:
- The same line-items on different companies’ income statements may be identified by different words, but look for the commonalities between the names.
- Sales should be recorded in the periods they were earned and closed, not just where they look the best.
- EBITDA : Earnings Before Interest Taxation Depreciation and Amoritization
- Comparing the income statement with a benchmark like a budget, or prior year, you can increase your understanding of a company’s well being.
Starting the chapter, we learn that the Income Statement can be known by a couple other different names; Profit and Loss (P&L), as well as Statement of Income and Expenses.
Some non-financial managers are surprised not to see specific individual transactions on an income statement that they thought should be there. There are two reasons why an income statement might not have recorded a transaction in the time period that a manager might think it should have shown up:
- time passage between the time when the invoice was sent to the supplier or customer, and the time when the invoice was actually paid.
- confusion over when a transaction should be recorded according to GAAP.
The second bullet may need some explaining. Transactions, according to GAAP, become irrevocable when the supplier has delivered something. Before a shipment is received, the purchased order, the invoice, all “agreements” are revocable, until something has actually been delivered. Therefore, when accounting for a purchase, the transaction is recorded when the goods are received.
Sales income is only recognized for those exchanges of products or services, regularly offered to the customer under normal business circumstances. When a business sells buildings or land (unless the business of the business is selling buildings and land), those sales are not recognized as sales. Money earned by sales of services might be called revenue, but the terms sales and revenue are interchangeable.
Cost of sales (cost of goods sold) are those expenses directly related to making the sale. Delivery, raw materials, even training, sometimes commission, all contribute to cost of sales.
Take away cost of sales, from the sales themselves, and you’re left with gross profit. Gross profit is an important number because the business will pay for operating expenses based on gross sales. Operating expenses are those expenses that are needed to keep the business running. R&D, administrative expenses and sales and marketing all are part of the operating expenses. There may be other expenses, and some companies might not list the categories above. Each business will record those expenses using categories that describe the biggest impacts to the business.
Research and development, engineering expenses, and product development are all terms used to define the processes that happen in order to create new sales. Because all of these activities happen before the sale is to be made, they are not a part of cost of sales, and therefore must be paid as part of operating expenses.
Sales and Marketing expenses, outside of those expenses directly related to the cost of sales (eg commissions), include brand development, market research and test marketing.
General and Administrative expense (G&A) is a catch all category for all those expenses that do not fit into the other categories listed in the Operating expenses category. Listed in the G&A are: executive salaries, human resources, employee benefits, and all costs associated with supporting the administration of a company.
EBITDA is mentioned passingly as a new trend, but whose merit has not been judged yet.
Other income and expenses is found next on the Income statement, and contains income/expenses that are not a part of normal day-to-day business, but could significantly impact net income. Some examples of the numbers that might make up other income are: interest income/interest expense, gain/loss on equipment sold, and gain/loss on investments that are non-essential to the business.
All of the incomes and expenses on the income statement up until the point just after Other income/expenses, sum to a number called Pretax Income. On the income statement, tax estimates are shown for income taxes that will be paid, and the company’s final bottom line, net income is shown right before dividends are taken out and distributed.
Earnings are distributed through shares of the company. Earnings per share (EPS) can tell outsiders about the profitability of the company, and also can hint at price increases for stock options (in a publicly traded company). EPS can be calculated a number of ways though, so there are two numbers that get shown on the income statement, EPS, and fully diluted EPS. Fully diluted EPS takes into account the shares that no one owns, that could be bought before dividends are distributed, and therefore could dilute each individuals’ earnings.
The final point the chapter makes is that the income statement gives much more insight when compared to a benchmark. Those benchmarks could be the income statement for the same time last year, a company’s balance sheet, or even another income statement from another company within the same market, for the same time period.