Objectives: Financial Analysis LAP 4 Describe the components of an income statement. Explain how the income statement is utilized by businesses. (Income Statements) Financial Analysis LAP 4 Performance Indicator FI:094

Describe the components of an income statement.

Typical Saturday night at the local cinema You’re ready for the main attraction. But wait—the previews come first! They provide a “sneak peek,” but not an overall view of a movie. Viewing a business’s financial statements is a lot like this. Some financial statements give “previews.” The income statement is the feature presentation. Gives the entire financial picture Summarizes where the business’s money came from and where it went

Income Statements Lists all revenues and expenses for a certain time period, usually one year Example A summary of a business’s income and expenses over a period of time

Earnings statement A business’s having income doesn’t necessarily mean that it is earning a profit. Income Statement Aliases Profit is the income left over once all expenses are paid. The income statement is the only financial statement that enables the business to look at its net profit.

Its information is used by businesses to make a variety of decisions that affect how the business will operate. Operating statement Income Statement Aliases How to invest money Ways to cut back on expenses How to invest money Ways to cut back on expenses

Operating statement Income Statement Aliases The cash-flow statement The balance sheet The statement is also used to create other financial documents that direct how the business will operate:

Profit-and-loss statement Income Statement Aliases If the outcome is positive, the business has a profit. Traditional term for the income statement Explains what it accomplishes very well Basic calculation used to analyze an income statement is “income minus expenses.” If the outcome is negative, the business has a loss. Over time, however, income statement has become the common business term for this important summary.

Income Statement Categories Five Main Categories on an Income Statement Operating expenses Revenue Cost of goods sold/Cost of sales Gross profit Net income/profit

The total amount of money earned by a business Includes: Sales of the business’s goods and services Interest earned from bank accounts Returns on investments Sale of the business’s assets Sales of the business’s goods and services Interest earned from bank accounts Returns on investments Sale of the business’s assets All money coming in to the business, no matter what the source, is revenue.

Raw materials Manufacturing overhead Packaging Shipping Labor Raw materials Manufacturing overhead Packaging Shipping Labor Includes all direct costs to obtain and/or produce the goods or services that a business sells, such as: Supplies Unsold items Stolen items Returned items Supplies Unsold items Stolen items Returned items Cost of Goods Sold / Cost of Sales

Manufacturers have costs associated with making a product—“cost of goods sold.” Different businesses have different kinds of costs. Retailers have costs associated with obtaining goods from others and reselling them to ultimate users, and service providers are concerned with all costs directly associated with providing their services—“cost of sales.” Cost of Goods Sold / Cost of Sales

Determined by subtracting the cost of goods sold from revenue The total profit made before all other remaining expenses have been deducted Determined by subtracting the cost of goods sold from revenue The total profit made before all other remaining expenses have been deducted Determining the gross profit helps businesses to see how much money they’ve invested in making or obtaining their products versus how much it costs to run the business. In this way, businesses are able to see what is costing the most money and can target trouble areas more effectively.

Employee wages/salaries Advertising Insurance Utilities Addresses all other expenses associated with the business, including: Mortgage or rent Administrative costs Interest paid on outstanding loans

The expenses incurred from keeping a business’s doors open. The business pays these expenses so it can operate. May be either: Variable —amounts that are constantly changing, such as advertising costs Fixed —amounts that stay the same for long periods of time, such as rent

Business’s final profit Money the company actually makes after all expenses have been deducted and taxes paid Usually considered most important item on income statement Answers the question, “Is this business profitable?” —

Income statements determine final profit and are also used to develop other financial documents. They must be as accurate as possible. — Sometimes called net profit or net earnings Accuracy of this “bottom line” depends on accuracy of reported revenues and expenses. Life of the business can depend on it.

 Income statements show a business’s total financial picture—the good, the bad, and the ugly. The Whole Picture  This picture is cumulative.  Each income statement represents a total for a specific time period— usually one year.

 Income statements can be produced for quarters or months if desired. The Whole Picture  A business must be able to see cumulative totals so that it can see where it is successful and where there might be trouble brewing.  To ensure that the total for each category is correct, a business will often develop a more complex in- come statement with an extensive breakdown under each category.

Explain how the income statement is utilized by businesses.

Financial Ratios When developing the income statement, a business must first gather information from each department or division that relates to: Revenue Cost of goods sold/Cost of sales Operating expenses Revenue Cost of goods sold/Cost of sales Operating expenses This information is then compiled, totaled, and used to calculate gross profit and net profit.

Financial Ratios Once this is completed, the business will transform the final numbers into financial ratios. A ratio is created when one number is divided into another—it shows the relationship between the numbers. By category Over time To the competition By category Over time To the competition Over 100 different ratios can be created from a business’s financial statements. Ratios can be compared:

Is the business spending too much on operating expenses? Are sales keeping up with expenses? Is the business earning more profit than it is spending for the cost of goods sold? Is the business spending too much on operating expenses? Are sales keeping up with expenses? Is the business earning more profit than it is spending for the cost of goods sold?  By themselves, elements of an income statement are simply categories and totals.  Businesses need to be able to see how categories are affecting each other and the bottom line.  The answers to these questions are critical for the business’s stability and financial success.

Comparing Categories Over Time Businesses not only need to know their financial circumstance for one year, but also over time. What if a business wants to know how much it spent on expenses last year compared to this year? To determine this, a business needs to be able to compare numbers from income statements from different years. Or, what if it wants to know if profit has been improving over the last five years? Monitoring sales growth is critical for the business’s success.

Competitive Analysis Is the business improving or deteriorating? Is it generating enough sales to obtain an acceptable profit? How effectively is the business managing operating expenses? Is the business producing a product for more or less cost than its competitors? Is the business improving or deteriorating? Is it generating enough sales to obtain an acceptable profit? How effectively is the business managing operating expenses? Is the business producing a product for more or less cost than its competitors? Even when a business is earning a profit, it still needs to know how it is doing by industry standards. By comparing numbers from its income statement with those of its competitors, a business will know if it is operating as profitably as it should be. A competitive analysis helps a business to see its strengths and weaknesses in relation to those of the competition.

Who Analyzes Income Statements? Look at ratios to monitor operations and determine whether their company is running efficiently Also use the income statement to monitor yearly profit Top executives and managers

Who Analyzes Income Statements? Utilize information generated from the income statement to review the financial status of a business Responsible for deciding if a business is granted a loan or a cash advance The income statement helps creditors assess the business’s credit- worthiness and the risk of extending credit. Creditors

Who Analyzes Income Statements? Have part ownership of a business Use income statement to monitor profit levels Investors and potential investors The value of the stock depends on: How much profit the business has been able to make over time The potential of the business to continue making a profit

Who Analyzes Income Statements? Investors and potential investors Ratios calculated from the income statement: Allow investors to monitor how much profit the business is making Assure them that they are getting a good return on their investment

Income statements don’t have to be just for businesses. You can make a personal income statement for yourself! Over the next month, keep track of all the money you bring in: From your allowance From babysitting From mowing lawns From gifts or birthday money you receive

Also, keep track of all the money you spend: On lunch On movies or video games On library fines On gifts for family or friends What’s your total at the end of the month? Are you making a profit or suffering a loss? How can this information help you as you budget in the future?

 The accuracy of a business’s income statement is a matter of great importance.  A number of business and investment decisions are made based on the figures that appear on the document.  Sometimes, the business is unhappy with the story those figures tell. A non-profit organization may not want to show an excess of income at the end of the year because it might discourage donors from giving money. Donors might not think it’s necessary to give if the organization seems to have plenty of resources.

 Sometimes, the business is unhappy with the story those figures tell. To solve this problem, the organization may tuck some of the extra income away in a column on the income statement labeled something such as “reserve funding.” That way, the organization doesn’t appear to have as much excess income at the end of the year.

 The organization isn’t really hiding the income— it’s right there on the income statement, but not in the final figure at the bottom.  What do you think?  Is this an ethical practice?  The organization isn’t really hiding the income— it’s right there on the income statement, but not in the final figure at the bottom.  What do you think?  Is this an ethical practice?

Acknowledgments Original Developers: Lelia Ventling and Sarah Bartlett Borich MarkED Version 1.0 MarkED Resource Center Copyright © 2007 Version 1.0 MarkED Resource Center Copyright © 2007

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