pillars of wall street - financial statement analysis - income statement

Question 1

what does income statement tell us?

Answer 1

gives the profitability of a business

gives revenue, expenses (COGS, SG&A, interest, taxes)

gives net income figure

does not tell us anything about cash flow

Question 2

if income statement shows a company is not profitable (negative net income), how does it stay in business?

Answer 2

it gets a cash infusion either through an equity investment or by taking on debt

Question 3

operating section of income statement

Answer 3

all of the items that can’t be changed no matter who the management/ceo are

it includes revenue, COGS, gross income, SG&A, operating income line items

Question 4

COGS

Answer 4

cost of goods sold

these are variable costs related to direct production of the company’s product inventory

includes production labor, warehousing, freight

Question 5

gross income

Answer 5

aka gross profit

= revenue - COGS

this is an important figure for retailers

Question 6

SG&A

Answer 6

selling, general and administrative

this is overhead expenses (ones not directly tied to production of inventory)

incl. labor, rent, utilities, advertising, ceo salary, marketing dept., finance dept., consultants your company has who go out and educate clients about your product/services

SG&A is a category of exclusion; meaning, if it’s not in COGS, then it must be in SG&A

Question 7

receivable impairement

Answer 7

accounts receivable that a company believes they will be unable to collect

Question 8

operating income

Answer 8

aka operating profit

= gross profit - SG&A - receivable impairment

this is an important figure for companies that have most of their expenses in the form of SG&A (companies with big marketing departments, for instance, are best compared using the operating income line item rather than gross income line item)

Question 9

non-operating section of income statement

Answer 9

involves decision of management like how the company is financed (its capital structure)

line items in the non-operating section of income statement include interest expense, taxes, pre-tax income and net income

Question 10

net income

Answer 10

aka earnings

= operating income - interest on debt - taxes

this is the figure used to determine earnings per share

Question 11

cash accounting

Answer 11

revenue only recognized when cash is received

expenses only recognized when cash is paid

Question 12

accrual accounting

Answer 12

recognizes economic events (revenue and expenses) regardless of when cash is exchanged

produces more accurate picture of company’s overall financial position

GAAP requires accrual accounting; all publicly-traded companies must use accrual accounting

Question 13

revenue recognition policy

Answer 13

top line of income statement must always give net revenue/sales, not gross revenue/sales

must recognize revenue when it is actually earned, not when cash changes hands

Question 14

net revenue

Answer 14

revenue less adjustments for returns and other allowances

Question 15

matching principle

Answer 15

under accrual accounting, expense recognition must match expenses with corresponding revenue for the period

Question 16

EBIT and EBITDA

Answer 16

operating income is a GAAP number

EBIT and EBITDA are the more commonly used terms by financial analysts for operating income/operating profit

when to use EBIT or EBITDA? for companies that utilize a lot of equipment (factories and whatnot), use EBITDA; these companies must make large investments in cap. ex. to stay viable and shouldn’t be penalized for these investments

both EBIT and EBITDA are pre-capital structure numbers; they let you figure out how a company is doing from an operations standpoint with management decisions to take on debt and tax considerations unique to particular cities parsed out; this way, you can compare how two companies are performing relative to one another without the impacts of which city they happen to be in or how much debt they have taken on factored into the analysis

Question 17

when is EBITDA used?

Answer 17

it’s the most valuable metric when valuing companies

also used when considering leverage

also used as a proxy for cash flow when doing discounted cash flow models because EBITDA adds back D & A which are non-cash expenses

Question 18

calculating EBIT and EBITDA

Answer 18

take operating profit (aka operating income) line item from income statement

next, look above the operating income line item and in the footnotes to see if there is anything that really shouldn’t be included in the EBIT/EBITDA calculation; the only items that should be included must follow the three Cs principle - core, continuing, controlled

finally, add back D & A

Question 19

the three Cs

Answer 19

on an income statement, any line item that is considered revenue, sales or income for the business must be:

core - central to the company’s business model

continuing - recurring form of revenue for the business

controlled - the company has at least 50% ownership of the division that is yielding the income

Question 20

how to figure out your D & A

Answer 20

meaning depreciation and amortization

D&A live in three different line items on income statement:

1 - D&A related to direct production of inventory will be in COGS line item

2 - D&A related to overhead will be in the SG&A line item

3 - D&A sometimes have their own line items

note that for most companies, D&A will be in at least two of the above three line items; so, to calculate historical EBITDA, always look at the operating section of the cash flow statement to figure out total D&A for the business; don’t fall into trap of just looking at the D&A line item on the income statement; must look at the cash flow statement!

Question 21

effective tax rate vs. marginal tax rate

Answer 21

ETR
is average tax rate of company
ETR = tax amount / pre-tax profit

MTR
is tax applied to next dollar of earnings
it is the statutory tax rate where company is domiciled
21% federal tax (currently) + applicable state tax

Question 22

difference between net income and EBIT/EBITDA

Answer 22

EBIT and EBITDA must follow 3 Cs

but net income only has to be continuing; the shareholders don’t care where the profitability comes from as long as it is ongoing

Question 23

earnings per share

Answer 23

total net income doesn’t really apply at the individual shareholder level; shareholders are more interested in EPS

this is the most common performance measure for public companies

it is the earnings that are available to common share holders

Basic EPS = [net income - preferred dividends] / WASO

Question 24

diluted EPS

Answer 24

wall street doesn’t pay much attention Basic EPS; more likely to use Diluted EPS

accounts for potentially dilutive securities (meaning anything that can be converted to common stock in the future) including options, RSUs, convertible preferred stock and debt, etc.; when converted, these types of securities increase total amount of stock outstanding

Diluted EPS can never be greater than Basic EPS

Question 25

preferred dividends

Answer 25

are dividends on preferred stock, a form of equity senior to common stock that receives dividends ahead of common stock

Question 26

WASO

Answer 26

weighted average shares outstanding

Question 27

profitability ratios

Answer 27

what financial analysts pay attention to compare different companies quickly

gross margin
operating margin
EBIT margin
EBITDA margin
net income (i.e. profit) margin

to calculate each ratio, take corresponding line item and divide by total sales

different ratios are important for different types of companies: retailers use gross margin or EBITDA margin, mature companies with complex capital structure like utility companies use net income margin