Chapter 3: Income Statement and Statement of Stockholders’ Equity Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 3-1 Learning about earnings, the bottom line, Is very important most of the time. A phony number Just may encumber Those folks trying to make more than a dime. --A. Ormiston

Income Statement and Statement of Stockholders’ Equity Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 3-2 Operating performance of a firm has traditionally been measured by its success generating earnings – the “bottom line.” Annual reports include three years of income statements and stockholder’s equity.

The Income Statement Also called the statement of earnings Presents a business firm’s revenues expenses net income earnings per share Reveals management’s ability to translate sales dollars into profits Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 3-3

The Income Statement Multiple-step format Intermediate profit measures include Gross profit Operating profit Earnings before income taxes This format should be used for analysis purposes. The analyst should redo an income statement that is not already in the multiple-step format before analyzing. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 3-4

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 3-5

The Income Statement Regardless of format, certain special items must be disclosed separately on an income statement: Discontinued operations Extraordinary transactions Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 3-6

Common-Size Income Statement Useful analytical tool to compare firms with different levels of sales or total assets facilitate internal or structural analysis evaluate trends make industry comparisons Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 3-7

Common-Size Income Statement Expresses each income statement item as a percentage of net sales Shows the relative magnitude of various expenses relative to sales, the profit percentages, and the relative importance of “other” revenues and expenses Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 3-8

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 3-9

Gross Profit (or Gross Margin) First step of profit measurement Difference between net sales and COGS Key analytical tool in assessing operating performance How well does management control the expenses of production? Given by Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 3-10

Operating Profit Second step of profit determination – Also called earnings before interest and taxes (EBIT) Measures overall performance of company’s operations. – How well does management control the expenses of running the company apart from financing and investing activities and separate from tax considerations Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 3-11 Given by

Operating Expenses Examples Selling and administrative − relate to the sale of products or services − salaries, rent, insurance, utilities, supplies, depreciation (sometimes), etc. Advertising − major expense when marketing is an important element of success Lease payments Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 3-12

Earnings Before Income Taxes/ Effective Tax Rate Earnings before income taxes is the profit recognized before deduction of income tax expense. Income taxes paid may differ from income tax expense (deferred taxes) Effective tax rate is given by Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 3-13

Special Items Often one-time items that will not recur in the future Discontinued operations Occur when a firm sells or discontinues a clearly distinguishable portion of its business Extraordinary gains and losses Unusual in nature Not expected to recur in the foreseeable future Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 3-14

Net Earnings Also called the “bottom line” Represents profit after consideration of all revenue and expense Net profit margin shows the percentage of profit earned on every sales dollar. Net profit margin is given by Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 3-15

Earnings Per Common Share (EPS) EPS is the net earnings available to common stockholders for the period divided by the average number of common stock shares outstanding. If a firm has “complex” capital structure, it will report basic and diluted earnings per common share. – The complexity comes from securities or contracts that could be turned into stock Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 3-16

Comprehensive Income Currently, there are four items that may comprise a company’s other comprehensive income: Foreign currency translation effects Unrealized gains and losses Additional pension liabilities Cash flow hedges Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 3-17

T he Statement of Stockholders’ Equity Important link between the balance sheet and the income statement Documents changes in the balance sheet equity accounts from one accounting period to the next Can also be presented in a supplementary schedule or in a note Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 3-18

The Statement of Stockholders’ Equity Includes transactions such as stock dividends − issuance of additional shares of stock in proportion to current ownership − reduce retained earnings account stock splits − used to lower the market price of shares to make common stock more affordable reverse stock splits − occurs when outstanding shares are decreased Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 3-19

Buffett and Gates Part 1 of 8 – Part 2 of 8 – Part 3 of 8 – Part 4 of 8 – Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 1-20