The income statement reports the revenue and expenses of the firm over a period of time. The income statement is sometimes refered to as the statement of operations or Profit and Loss Statement. The income statement relies on the equation:
In other words, Income Statement serves the purpose of providing the investors and other users of financial statements with most appropriate profitability of the entity net of expenses incurred by the company. In an elaborated manner, income statement helps an investor to assess as how the business has performed by giving a summary of how the business incurs its revenue and expenses through operating and non-operating activities and finally, a bottom line profit is declared in the income statement which is available to the shareholders.
Both Operating and Non-Operating are the two integral sections of the Income Statement and have following components:
Revenue: It refers to income earned by the entity from regular operations or primary course of business. Usually only net revenues(Sales- Sales Returns) are accounted for in the income statement. It should be noted that sales and revenue are sometimes used synonymously. However, sales is just one component of revenue.
Expenses: Expenses refers to the cash outflows/ amount incurred to generate revenue and include cost of goods sold, operating expenses, interest and taxes. However, only cash outflows that are related to entity’s ongoing operations are included in operating expenses and following are some of the prevalent operating expenses:
Cost of Goods Sold: It refers to cost of goods produced/manufactured by the entity and is finally sold as part of its major operations. Cost of Goods Sold includes material cost, direct labor and any overhead costs.
Selling, General and Administration Expenses: SG&A Expenses are not part of cost of goods sold and consist of combined payroll cost:
Selling Expenses: It refers to expenses related to or quintessential to sell the product for instance commissions, travel expenses and advertisement etc.
General and Administrative (G&A) expenses – These expenses related to manage the business operations and administrative work i.e salaries of the employees, legal and professional fees, insurances, rent etc.
Depreciation / Amortization – Depreciation refers to systematic allocation of asset’s cost over time. In other words, it is a non-cash- operating expense relating to reduction of value of tangible asset over time. An asset depreciate because of following reason:
- Wear and Tear: Machinery being used in production process may depreciate because of the wear and tear which is possible with continued use of machinery for extended years.
- Obsolence: A product may be considered as obsolete and hence is depreciated because there are new and better models available with better efficiency and improved production capacity.
- Research & Development (R&D) expenses – As the name suggests, these expenses are related to research and development so conducted and the one being planned for the future.
Also to be noted that all the expenses are accounted together by their nature or function. For instance, presenting all the depreciation expenses from manufacturing and administrative together in one line of the income statement is an example of grouping by nature of the expenses.Contrary to it, combining all costs associated with manufacturing as cost fo goods sold is an example of grouping by function.
- Other revenues or gains – Income Statement also includes gains and losses, which result from incidental transactions outside the firm’s primary business activity. For Example, a firm might sell surplus equipment used in its manufacturing operation that is no longer needed. The difference between the sales price and book value is reported as a gain or loss in the income statement
- Finance costs – It refers to interest expenses on amount so borrowed as long term debt from various creditors. Some entities may also include cost of raising the loan i.e bank charges as part of finance costs.
- Income tax expense – Total amount of income tax paid by the entity during current operating cycle and also tax due during the current operating cycle.
Sample Income Statement
Income Statement for XYZ Inc for the year ended 31.12.2013
Statement of Financial Position/Balance Sheet:
Also known as Statement of Financial Position, Balance Sheet is one of the financial statement which summarizes the Assets, Liabilities and Equity of the company. In other words, it indicates as what the company owns, owes and the amount invested by the shareholders respectively. The Balance Sheet follow the following equation:
Assets= Liabilities + Equity
This is important for the balance sheet to tally as since the accounting system is based on Double Entry book Keeping System, any effect of one component of Balance Sheet will equally affect other component.
It is important to note that most of the entities follow the classified balance sheet where each component of Asset, Liabilities and Equity is indicated by the company:
Assets are the economic benefits owned by the company as a result of previous transaction and are classified as Current Asset, Non-Current/Fixed Assets and Long Term Investments:
i)Current Assets: Current Assets are that portion of Total Assets that are expected to be converted into cash within an year or operating cycle whichever is longer. For instance, Inventory, trade receivables are some examples of current assets.
ii) Non-Current Assets: Non-Current Assets which are also known as Fixed Assets are those assets which cannot or will not be converted into cash within one year or an operating year whichever is less. These assets help in revenue generation of the entity. For Instance, Machinery, Buildings etc are some examples of long term assets.
iii)Long Term Investments: Any such investment which is likely to be matured after an operating cycle is termed as Long Term Investments.
Liabilities are the obligations which are owed by an entity as a result of its previous transaction that are expected to result in an outflow of economic benefit in the present operating cycle or in future. Liabilities are further classified as Current Liabilities and Non-Current Liabilities.
Current Liabilities: Current Liabilities are the debt and obligations of the company which are to be paid during an year or operating cycle whichever is longer. For Instance, Trade Payables and Bank Overdraft are some example of Current Liabilities.
Non-Current Liabilities: Non-Current Liabilities are those section of liabilities which are due to be paid after an year or longer term in the future. For Instance, Debentures and Bonds are some examples of long term liabilities.
Also known as Stock holder Equity, it indicates what actuallu a firm owes to its owner. Equity is created by the financing activities of the entity and also by operating activities of the company where it helps to create reserves for the company. Following is the some common equity accounts which are generally found in Balance Sheet of a public entity:
- Capital Stock
- Additional Paid in Capital
- Treasury Stock
- Retained Earnings
Sample Balance Sheet
Balance Sheet of XYZ Inc as at 31.12.2013
Company: TESCO PLC
These ratios analyse the ability the short term ability of a firm to meet its debt obligations. Generally two measures of Liquidity Ratios are used by analyst to adjudge the liquidity position of the company: (Yahoo Voice, 2011)
- Current Ratio
- Quick Ratio/Acid Test Ratio
1) Current Ratio: Calculated as ratio of Current Asset and Current liability, this liquidity ratio is considered to be true indicator of a firm’s liquidity. The average industry current ratio is 2:1.
- Current Ratio: Current Assets/ Current Liabilities
2) Quick Ratio: This ratio is a more stringent measure of firm’s liquidity as it excludes Inventory and prepaid expenses from current ratio while current liabilities remain same. The average industry quick ratio is 1:1.
- Quick Ratio: Current Assets – Inventory/ Current Liabilities
Our analysis has indicated that during an year, the liquidity of the company has improved only marginally with current ratio increasing from 0.66 to 0.68 while the quick ratio has increased from 0.48 to 0.49. However, both the ratios are not in line with industry standards which indicates that the entity is low on liquidity when compared to its peers.
2) Profitability Measures:
These ratios access the profitability of the entity and can said to be the true indicator for accessing the profitability of the concerned company.
i)Net Profit Margins: Net Profit/ Revenue*100
These ratios are calculated to adjudge the net profit margins of the company after both operating and non-operating expenses are deducted from Gross Profits. It is an important source to ascertain the profitability of the entity.
ii) Operating Profit Margins: Operating Profit/Revenue*100
Calculated as ratio of Operating Profit and Revenue, Operating Ratio is yet another source of profitability as it indicates as how much margin the company is earning from its operations and before deducting any non-operating expenses.
iii)Return on Equity: Net Income/Total Equity
This ratio measures profitability relative to funds invested in the company by the common stockholders.
The profitability analysis of the company clarifies the alarming situation in the company which during an year has been running on extremely low profitability margins. Although the operating margins of the company has decreased from 4.29% to 3.37%, the major concern which might pose a serious threat to the company and loss of faith of investors is the 0.19% Net Margin and 0.74% ROE. These two factors were unable to reach even the single digit mark and low ROE will surely discourage the investors of the company.
3) Solvency/Gearing Ratios:
These ratios are used to adjudge the debt and equity component in the capital structure of the company. In other words, these ratios indicates percentage of operations being financed with borrowed funds and also long term solvency of the company.
i)Debt to Equity Ratio:
Debt to Equity ratio is one of the most popular way of measuring a firm’s use of fixed cost financing sources. Higher the ratio, more is the financial risk involved in the firm’s operations because of bankruptcy threat associated with debt financing. However, extremely low debt financing may indicate that creditors are now not willing to lend their funds to the entity.
ii)Interest Coverage Ratio: Operating Earning/ Interest Expense
This ratio is a true measure of firm’s ability to pay off its interest paying obligations. Lower the ratio, more is the probability that the firm will default or will face difficulty in meeting its interest payments.
Refering to the above ratios we can easily judge that low interest coverage ratio of the entity is an indication that the firm will face difficulty in meeting its interest obligations. This is also validated from the fact that the company is now hovering in low profitability margins and thus, low debt equity ratio is not a sustainable indication as considering low margins and low interest coverage ratio, creditors might not be interested in funding TESCO’s operations.
Also known as Activity Ratios, these ratios are used to judge how efficiently a company is using its assets to generate revenue for the company.
1)Working Capital Turnover: Revenue/ Working Capital
This ratio indicates as whether the company has effectively used its working capital to generate revenue.
Working Capital : Current Assets- Current Liabilities
2012: 12863-19249= -$6386
ii) Inventory Turnover Ratio: COGS/ Inventory
This ratio measures the efficiency with respect to its processing and inventory management. In other words, it indicates how efficiently the entity is using its inventory.
Just like other sections of Ratio Analysis, the efficiency is not surprising is it also tells the tale of ruining financial condition of TESCO Plc. Declining Working Capital Ratio and Inventory Turnover Ratio is an indication that the entity is not only losing profit margins and is working under poor solvency but also poor efficiency of its assets to generate revenue.
Understanding Cash Flow Statement
The cash flow statement provides information beyond what is shown in the income statement. Since the income statement is made on the accrual basis of accounting rather than cash basis, it will always differ from the cash flow statement. The cash flow statement provides the following information:
- Information about the company’s cash cash receipts and cash payments during an accounting period
- Information about the company’s operating, investing and financing cash flow activities
- A transparent view of company’s performance as it provides an understanding of the impact’s of accrual accounting events on cash flows.
The cash flow statement reconciles the beginning and ending balance of cash over an accounting period. The change in cash is a result of the firm’s operating, investing and financing activities as follows:
Operating Cash Flow
+Investing Cash Flow
+Financing Cash Flow
= Change in cash balance
+ Beginning Cash Balance
= Ending Cash Balance
Its is important to understand that all the items on income statement are recorded using accrual basis of accounting and thus it shows a company’s profitability on accrual accounting basis. In other words, it illustrates a company’s revenue, expenses and net income through accrual accounting which requires that an entity must record its transaction i.e whether it is related to income or expenses, when they are incurred. Thus, the entries are posted not when cash is received or is paid, but rather when they are earned or expended. Although the accrual basis of accounting, has associated benefits with it as it shows a accurate picture of the company’s profitability but at the same time can be used as a tool for manipulating the accounting picture.
Thus, these shortcomings are addressed by cash flow statement. The cash flow statement identifies all of the cash inflows and outflows of a business and whole of the statement is made on cash basis rather than accrual basis. Thus, an entity cannot easily manipulate its cash position and it is through this financial statement that actual position of an entity is disclosed. Thus, for the purpose of obtaining a strong and accurate financial analysis, both income statement and cash flow statement should be used in conjuction because if a company has reported a high net income then it must be supported with high cash flows and vice versa and if this is not the case, then it is needed to investigate why such discrepancy exists.
Interpreting TESCO’s Cash Flow Statement:
Refering to the latest cash flow statement of the company we can analyze that the entity has increased the cash flow by $220 during 2013 while the ending cash balance in total is $2531. Following is the detailed discussion of cash flow statemen of TESCO Plc:
Cash flow from Operating Activities:
The fiscal year of 2013 ended with CFO of $2837 after all the non-cash expenses which amounted to $3159 were added back along change in inventory and other working capital items.
Cash flow from Investing Activities:
The cash flow statement indicates that the company went through number of investing activities during 2013 and ended with cash outflow of $278. Major investing activities were relating to investment in properties amounting to ($2619) and purchase of intangible assets of ($369).
Entity is also engaged in sale of its assets amounting to $1351 and of investment relating to $1427.
Cash flow from Financing Activities:
Major transaction relating to financing activity was relating to debt repayment of ($3022) and cash dividend paid amounting to ($1184). Apart from repayments, company also involved in issue of fresh debt of $1820 which in conjunction with debt and dividend payments led to cash outflow of ($2365) from financing activities.(Peavler)
Peavler, R. (n.d.). Are a Firm's Cash Flow and Profit Different? Retrieved January 9, 2014, from About.com: http://bizfinance.about.com/od/yourfinancialposition/f/Cash_Flow_vs_Profit.htm
Robinson, T. (2011). Financial Statement Analysis: An Introduction. In CFA Institute, Financial Reporting and Analysis. Boston: Custom.
Robinson, T. (2011). Understanding Cah Flow Statement. In CFA Institute, Financial Reporting and Analysis. Boston: Custom.
Robinson, T. (2011). Understanding the Income Statement. In CFA Institute, Financial Reporting and Analysis. Boston: Custom.