02 Income statement Flashcards
Income Statement is part of the Annual Accounts:
- Legal obligation of every corporation’s management to prepare its annual accounts.
- Then, it must be submitted for approval at the general assembly of shareholders (and must be signed).
- It must be filed for recording in the Commercial Registry (with some exceptions)
- The Income Statement (IS) measures the performance of the firm over a period of time.
- IS contains the revenues generated (the achievements) less the expenses incurred (the efforts).
Income – Expenses = Net Profit (= Net Income = Result)
- Net profit is a summary of the performance of the firm.
- These records provide information about a company’s ability to generate net income (profit); by increasing revenues, reducing expenses, or both.
Consumption of materials: is what the company spends to manufacture or to purchase the products to be sold. In a company that provides services we do not have this concept of expenses.
It includes consumed materials (raw materials, packaging,…). We cannot consider the cost of materials if it has not been sold, because it has not been consumed after being purchased. In fact, part of material purchased might still be at the company’s warehouse at the end of the year.
To calculate the cost of materials consumed , we need to know the value of the stock in the warehouse at the beginning of the period and the value which remains in the warehouse at the end of the same period.
The material consumed would be equivalent to purchases only in the event that the initial stock were zero and all of it is sold during the period.
Consumed materials = Opening inventory + Purchases - Final stocks
- It is crucial to realize that revenues are not cash inflows and expenses are not cash outflows. Therefore, net profit is not the change in cash during the period.
- The reason is the accrual basis of accounting by which revenues and expenses are recognized in the accounts when revenues are earned or when the expenses are incurred, but not when cash is received or paid.
Depreciation: It represents how much of an asset’s value has been used during a period.
Depreciation is the accounting method used to allocate the cost of a tangible asset owned by the company (machinery, building, computers,…) over its useful life.
Depreciation is normally calculated using a linear method. This method consist of dividing evenly the depreciable value of the good over the years of its useful life, so that each year the depreciation is the same
• Income Statement Accrual vs. Cash Impact
- Revenue recognition criteria: A firm recognize revenues when fulfils the transaction. The firm has done all that it has promised to do for the customer: the firm has delivered the products or performed the services it has agreed to provide. That means that the company has earned the revenues.
- Net sales include the sales when they take place, this may not be the same month as when you are paid which will be 30 o 60 days later (if everything is ok).
- Sales rappels or discounts are deducted in net sales.
- Under the accrual method of accounting, sales and expenses can be booked before cash actually changes hands (difference vs. cash flow).
- It is only considered as “sales” when the company trades ordinary products of his activity. Therefore, there are not considered sales, for instance:
- Income interest from a bank deposit.
• Sale of a machinery, a plant or another asset.
• Classification of expenses in the IS:
üBy functional activity. For instance, all costs incurred in making the products that are sold (raw materials, production labor, utilities, depreciation & amortization of manufacturing equipment, etc.) are grouped into the cost of goods sold. Similarly, marketing and selling expenses contain the costs incurred in this function (salaries, utilities, etc.). The different portions of these costs are reported inside the different functions, but total salaries or total material expenses are no reported.
üBy nature. The expenses are classified by their nature: materials, salaries, utilities, etc. Unlike in by function IS, here we cannot tell how much raw materials and supplies were used in production, selling and administration or R&D. We can not determine the cost of goods sold and, therefore, gross profit. For that reason, we cannot know how much was expensed in selling and administration, or in R&D.
- More and more, large firms are switching to the by function format because it facilitates investors to make assessment about efficiency. In some industries the gross profit margin ( gross profit / sales) is closely monitored as its deterioration can signal trouble in operations.
- Cost of goods sold (COGS) is the direct cost of making the products that were sold to generate revenues:
• COGS:
üMaterial cost of the period:
+ Inventory cost at the beginning of the period
+ Additional Inventory purchased during the period
- Final Inventory at the end of the period
üDirect manufacturing labor is the total cost of personnel devoted to manufacturing of the goods.
üManufacturing expenses: workshop costs, energy consumption, regular maintenance, etc.
üDepreciation: refers to the reduction of cost of the fixed assets over its lifespan
• Depreciation of fixed assets.
- When the company acquires fixed assets such as plant, equipment, machinery, building and furniture, it is recognized as a tangible fixed asset in the Balance Sheet. (=> Investment and cash outflow impact).
- One of the main principles of accrual accounting requires that an asset’s cost is expensed based on the period over which the asset is used. (=> Expense but No cash impact).
- Depreciation is proportionate to the use of the asset in that specific year. It can be done by using straight-line method or an accelerated depreciation method.
- The production plant includes land, building construction, installation and facilities. Land is not depreciated based on the period it is used.
- It is crucial to realize that depreciation has non-cash impact, since cash out have been done when the asset was purchased.
- Depreciation of long-term assets is required for both tax and accounting purposes.
ØExample of Depreciation:
- A company buys a piece of equipment for €50.000. It has to be recognized in the Balance Sheet as a fixed asset. Depreciation is the yearly cost expensed, based on the life of the asset, which is 10 years: 50.000/10= 5.000€/year depreciation.
- In case, it is estimated a residual value of €5.000; then depreciation expense is of (50.000-5.000)/10= 4.500€/year.
- 摊销Amortization usually refers to the reduction in the cost of the intangible assets over its lifespan, mostly done using straight-line method. The example of intangible assets are:
- patents, trademarks, lease rental agreements, concession rights, software, etc.
- Accruals: 应计费用 It is required to accrue salary bonus that are paid once per year but the expense is monthly. Also, it is required to accrue real expenses during the period but it is pending to receive the invoice. Then, when the invoice is received, it is matched against the accrued expense.
- Cost vs. Expense.
- Cost usually identifies an expenditure, so it means that you have expended resources in order to acquire something, transport it to your location and set it up.
- It should be capitalized and reflected as a fixed asset in the Balance Sheet: piece of equipment, inventory, etc.
- Expense refers to the consumption on the item acquired during the period. An expense is necessary in order to earn revenues.
• An operating expense is an ongoing cost, like utilities, rent or payroll. For example, the expense of rent is needed to have a location to sell from, to produce revenue.
• For example, the purchase of big copy printer involves capital expenditure (CAPEX) and the annual paper, toner and maintenance represents operating expenditure (OPEX)
• Examples Cost vs Expense:
ØThe cost of equipment used in manufacturing is initially reported as the long lived asset equipment. However, in each accounting period the company will report part of the asset’s cost as depreciation expense.
ØA retailer’s purchase of merchandise is initially reported as the current asset Inventory. When the merchandise is sold, the cost of the merchandise sold is removed from Inventory and is reported on the income statement as the expense entitled Cost of Goods Sold.
- Operating expenses or indirect expenses are the rest of expenses of the period needed to generate revenues, which are not directly linked to manufacturing.
- Research and Development are costs incurred to develop new knowledge in order to generate new products (or process) that will generate potential revenues (and margin).
- In some cases, R&D can be capitalized as an intangible fixed asset in the Balance Sheet and amortized in the Income Statement over its lifespan (under certain rules).
• Selling and Marketing expenses:
- Marketing and advertisement cost,
- Labor cost of salespeople
- 运送Freight out expenses
- Customer service expenses, etc.
• General and administrative expenses:
- Indirect labor cost for IT, HHRR, Finance, Tax & Legal, GM, etc.
- Indirect expenses such as offices renting, travelling expenses, outsourced services, cars renting, etc.
• Earnings Before Interest and Taxes (E.B.I.T.):
- It measures the profit of a company generated by its operations.
- E.B.I.T. is a useful metric for certain cases; for example:
An investor is comparing companies in an industry that operate in different tax environments and have different strategies for financing. Tax and interest expenses may distract from the core analysis: how effectively do these companies generate profit from their operations?
• Non-Operating expenses:
- Non-operating income and expenses are items that effect overall profitability but aren’t related to the operations of the business.
- Financial income/expenses:
- Expenses: debt interest, bank expenses, guarantee expenses, etc.
- Income: bank account interest income, deposit income, etc.
• Income Tax:
• Governments impose tax on business generated by the companies within their jurisdiction. Depending on the country, it could be about 25% on P.B.T.
After this tax percentage it is possible to apply for tax deductions -for example- R&D tax deduction. In large companies with R&D strategy , the final effective % taxation could be about 12%. (It depends on the tax legislation of each country).
Increasingly popular as a performance measure and used in M&A transactions:
EBITDA
Earnings
Before
Interest
Taxes
Depreciation and
Amortization
- Also, EBITDA = Net Profit + Interest + Taxes + Depreciation + Amortization
- More valid comparison of performance between companies:
- Not affected by the way the companies are financed.
- Not affected by subjective accounting criteria for depreciation or amortization.
