Introduction to Financial Statements

The income statement : Difference between earnings and revenues

let’s catch up with the terms ‘Earnings’ and ‘Revenues’- two totally different terms which may baffle a naive financial analyser.

EARNINGS

Earnings means – Profits. It’s that simple.

Now, in business, there are different names for it. The most popular being “bottom Line” and “net income”. It’s similar to the term “net pay” or “net income” or “net earnings” or “net salary” or “take home pay” on your pay slips. Just like your take home pay, earnings are the “take home pay” of a business. It represents how much money the company has left over, if any, after it’s paid the costs of doing business — payroll, raw materials, taxes, interest on loans, etc. Earnings are arguably the ultimate measure of growth of a business. Analysts want to find companies that are growing their earnings because this is what they keep after they’ve paid their bills. That’s why “earnings results” reports each quarter are eagerly awaited by stock investors.

REVENUES

Revenues means – The total amount of money a company receives from sale of goods and services (i.e. receipts BEFORE deducting all expenses). It’s also called “top-line” or “Total sales” or “gross income”. It’s similar to the term “gross pay” or “gross earnings” on your salary slip. If you take an income statement, revenues or sales will be displayed on the left hand side of the statement ( Horizontal format) or on top of the statement ( vertical format). When you deduct all the expenses from revenues the resultant figure is called earnings. Arguably, top-line growth is more important, but also a more misleading figure than bottom-line growth. It’s more important in the sense that any earnings growth is going to have to come from revenues. But it’s misleading because on its own it doesn’t tell you what the company is actually making in profits. (Since the numbers don’t reflect what the business has to pay out in expenses).

FORMS OF EARNINGS

We discussed earlier about earnings. It’s a company’s “profit.” The real issue is what goes into that income number. There are many flavors: EBT is earnings before taxes, EBIT is earnings before interest and taxes, EBDIT is earnings before depreciation ,interest and taxes, EAT is earnings after taxes and EBDITA means earnings before interest, taxes, depreciation and amortization. In other words, incomes before those costs have been subtracted.

MEASUREMENT OF EARNINGS -EPS

EPS is earnings per share, or the part of the company’s profit that is attributed to each individual share of stock. EPS is a good indicator of a company’s profitability, and is a very important ratio to look at while evaluating a certain stock.

HOW IS IT CALCULATED?

The formula for EPS is below.
(Net income – Dividends on Preferred Stock) / (Average Outstanding Shares)
In Beginner’s lessons- Fundamental analysis we have given  the formula (Net income – Dividends on Preferred Stock) / Outstanding Shares).You may wonder why “average outstanding shares” is used as denominator instead of outstanding shares . The reason is that EPS is reported over a certain period of time, and the number of outstanding shares will likely fluctuate in that period, so you can get a more accurate result by using the average number of outstanding shares.

WHY IS IT IMPORTANT?

EPS is considered by most investors to be the single most important ratio to use when evaluating a stock. However, some aspects of EPS can be misleading when comparing two different companies. For example, one company could use twice as much capital to generate the same amount of profit as another, but it is obviously not utilizing its capital as efficiently as the other company. However, these numbers are not reflected in the EPS, so it is important to remember that EPS alone doesn’t tell the whole story.

POINTS TO NOTE

When you analyse a company for it’s EPS, keep these points in mind:

  • You should always compare earnings growth relative to previous years / quarters. A steady increase in earnings per share is a good indicator of genuine growth and reduces the possibility that the company just had one great quarter which might not be sustained in the future.
  • Current quarterly earnings per share – Earnings must be up at least 10-20%.
  • Annual earnings per share – These figures should show meaningful growth for the last five years.
  • With that we complete our discussion on the difference between earnings and revenues. I said that quarterly earnings results influence stock prices. But Why? Why do results for a single quarter cause so much mayhem?
    To know the answer, you have read one more simple article: More about earnings quarter.

    Bye for now, have a nice day!

5 Comments

The Income statement: Profits

So far we know that sales less all type of expenses results in profit. We know a little bit more – we know that sales less direct expenses results in Gross profit and Gross profit less indirect expenses ( including taxes ) results in net profit. In this lesson we will introduce two more variations of net profit – the PBIT , PBT and PAT. ( Profit before interest and tax , Profit before tax and profit after tax)

Gross profit

Companies need to generate a healthy gross profit to cover up indirect expenses, taxes, financing cost (all indirect costs) and net profit. But how much is ‘healthy’? That varies from industry to industry and from company to company. To analyse a company’s gross profit , you need to do two things :
1. Compare the Gross profit ratio with competitors in the industry  and
2. Compare the Gross profit ratio with the past 5 year’s ratio.
Comparison with the peers will give you an idea about how competitive the company is and by comparing the last 5 years’ ratio will tell you whether the company is headed up or down.

Operating profit or EBIT


Gross profit minus operating expenses results in operating profit. This operating profit is also know by another name – EBIT. I.e., earnings before interest and tax (Pronounced as EE-bit). Some companies may write the same as PBIT (Profit before Interest and taxes). What has not been deducted is interest and taxes. Why? Because operating profit is the profit a business earns from the business it is in- from operations. Interest expense depend on whether the company has taken a bank loan or not and taxes don’t’ really have anything to do with how well you are running the company. The EBIT will be displayed in the income statement of any company.

EBT-or Earnings before taxes.

…Or profit before taxes (PBT). The term implies operating profit after deducting interest expense.

PAT/EAT.

Now let’s get to the bottom line: Net profit. (Also called Profit after tax (PAT) / or Earnings after tax (EAT)]. PAT is what is left over after everything is subtracted- direct expenses, indirect expenses, interest and taxes. When the analyst says “the company’s bottom line has shown considerable growth” what he means to say is that the company’s PAT has gone up. Some of the key ratios used to fundamentally analyse a company such as Earning Per share and Price earnings ratio are based on this PAT.

To analyse a company’s PAT, you need to the same routine as you did in Gross profit analysis:

1 Compare the PBT  ratio with competitors in the industry  and
2 Compare the PBT ratio with the past 5 year’s ratio.
Comparison with the peers will give you an idea about how competitive the company is and by comparing the last 5 years’ ratio will tell you whether the company is headed up or down.

EBDITA-

Before we close this section we need to look at one more important version of profit called EBDITA or Earnings before depreciation, interest, taxes and amortization.( Amortization is something we haven’t explained. For the time being understand that it’s non cash expenditure.) Some people think that EBDITA is a better measure of a company’s operating efficiency because it ignores non cash charges such as depreciation.

How to calculate these ratios have been given in the “Fundamental analysis” section. For you as an investor , it’s enough that you take out the EBDITA, PAT and PBIT figures. A comparison of these figures with the peers a for the past 5 years would give you a first hand impression about the company.

1 Comment

The Income statement: Understanding the components.

THE 5 COMPONENTS

Towards the end of the last post we wrote that the income statement has only 5 components, they are–

  • Sales ( or revenue or  income )
  • Direct cost
  • Gross profit (or it could be gross loss)
  • Indirect cost
  • Net profit (or it could be net loss)

So the question that remained to be answered was – Why does the income statement looks complicated if there are only 5 components? We will try to find the answer in this post. Before we explain that, we need to remember that –

  • Sales – direct costs = gross profit
  • Gross profit – indirect costs = net profit.

So, amoung the five elements, gross profit and net profit are single figures and will be displayed as such in the revenue statement. That leaves us with three figures – sales, direct cost and indirect costs.The Sales figure should be less complicated when compared to direct and indirect costs. These statements look complicated due to the complex nature of businesses done by big business houses.

For example a company like reliance has income from various sources like oil production business, oil refining and marketing business, petrochemicals  etc.These different segments may be separately shown in their revenue statement and hence, the first item in their revenue statement –‘sales’ would show four different figures and also the grand total of the four segments. When these figures are shown separately, it looks complicated. Such separate disclosure is essential for the reader to understand the proportion of income from different products. Separate disclosure can also be made based on geographical locations or any other viable separator. There will not be separate disclosure for credit sales and cash sales. (Recall the matching principle)

COSTS AND EXPENSES

There are two types of expenses.

(1) Directly related to the sale and

(2) Indirect expenses.

All expenses direct or indirect will be deducted from the revenues. By ‘directly related’ we mean that such costs are normally directly proportional to the volume of sales.  Direct costs are also known as “costs of sales” or “cost of goods sold”. This figure will be shown separately in the income statement as a deduction from the ‘Total revenues’ or ‘total sales’ figure.

The resultant figure after deduction is termed as ‘gross profit’. From the gross profit that the company has made, it needs to meet all its operational expenses like advertisement, salary to staff, rent etc.These expenses , which are not directly proportional to the sales are called indirect expenses. They are also known as ‘overheads’ or operating expenses.

Both direct costs and indirect cost also follow the matching principle and hence, those figures may not represent money actually paid.

CASH AND NON-CASH EXPENSES

At this point it is important for you to understand two more terms which are required to understand the profit and loss statement completely. They are: (1) cash expense and (2) non cash expense. Cash expense are expenses which are payable in cash. Non cash expenses are expenses for which there is no outflow of cash, but it will still be recorded as an expense. That’s because as far as an accountant is concerned the term expense has wider meaning and includes outflow of cash or outflow of other valuable assets or decreases in economic benefits or depletions of assets

Regardless of whether an expense is cash or non-cash in nature, it will be shown as deduction from the gross profit in an income statement. So if asset like machinery is used in business, the proportionate cost of machinery will be deducted as expense. Technically it’s called depreciation. It’s an expense. Precisely, it’s a non cash expense since there is no cash outflow.

Expenses – is it good or bad?

If a revenue statement shows too much expenses which affects the profitability of the company, that’s a bad sign. It’s important for the management to find out areas where they can save costs and expenses so that it improves the company’s profitability. Any such steps (for example spotting unnecessary down time in a manufacturing process) taken by a company is a positive sign.

We now know that expenses can be classified – as direct and indirect or as cash and non cash expense. Expenses can also be classified in many other ways –for example it can be classified on the basis of controllability –as controllable and un controllable expense or based on variability- as fixed and variable expenses.

In a revenue statement, instead of showing all the expenses as one figure, accountants would show it in maximum detail as possible so that the users, especially investors, can get further insights into the way in which the company is operating.

Now we hope you have understood why an income statement looks complicated at the beginning. It’s because, additional details are provided for clarity and transparency. At the end, any income statement can be trimmed down to just those five elements.

1 Comment

The Income statement : Understanding the “matching principle”.

Matching principle is one of the fundamental accounting principles followed by accountants worldwide. To understand matching principle, we will look at two business transactions first -

Transaction 1-

You run a whole sale super market. There is a 20% profit in every sale you make. There are many retailers who buy in bulk, mostly on credit. One such customer buys goods worth 5 lakhs on credit, on March 31 (last day of the financial year). Definitely, you have made a sale. Goods have gone from your go down and the stock reports will show goods worth 5 lakhs dispatched. Fine. But, on the other hand, the customer has not paid anything and hence the 5 lakhs sale will not bring in a penny to your bank account. There is also a probability that the customer can delay or default in his payments. In such a scenario, can we consider this as a sale in this financial year? If this is recorded as a sale, your revenue statement will show an additional 1 lakh as profit for which you are supposed to pay income tax. Whereas in reality, you have not got a penny.

Transaction 2 –

On the very same day (March 31st) salary for the month is to be paid. There is a total of Rs 50,000 to be paid. It is an expense to be deducted from the profits of that accounting year. But, since salary is always paid on the 5th of every month,the amount remains in your bank. Nothing has been paid. Should we add this as an expense of this year? If this is recorded as an expense, your expense will increase but at the same time you have not paid a penny from your bank account.

What’s the right decision?

In the first case, it is a sale and the transaction should be recorded. That’s because, if we look closely, we will understand that the profit has been already made although there is a delay in realizing the money. This sale was made due to the effort of your employees in the month of March. Hence, the second transaction should also be recorded in this financial year. The salary of 50,000 payable in March is an expense (payment delayed because due date is on 5th) against the profit of Rs 1 lakh made ( receipt delayed due to the credit policy of the company) .  You actual profit  is Rs 50,000, for which you have to pay tax.

If we do not record both these transactions this year, there are two side effects- for the year ending march 31 , your records will show no sale or profit but at the same time, your stock records will show an outflow of goods worth 5 lakhs. Next month, even if you do not make a single sale and close down your business, your accounts will still show a receipt of Rs 5 lakhs and an expense of Rs 50,000. If this carries on, your accounts will finally become a jungle of complications.

So, Accountants don’t mind if the customer has actually paid the cash or not. They don’t mind if an expense like salary is actually paid in cash or not. If it pertains to a particular period, they record it in that period itself. In the balance sheet ( where all receivables (assets)and payables (liabilities) of the company are recorded for the year) the accountant will show Rs 5 lakhs as an asset (cash) receivable and the unpaid salary as a liability to be payable.

Now the picture becomes clear for anyone who goes through the revenue statement and balance sheet. The company has made a sale of 5 lakhs ( will be shown as revenue from sales in the income statement) against which 20% is the profit. So the balance 80% is the purchase cost which will be first deducted from Rs 5 lakhs to arrive at Rs 1 lakh as gross profit. But as they can see in the balance sheet, the entire 5 lakhs is pending to be received. An expense of 50,000 will be shown against this profit. At the same time, the balance sheet will show the expense as a liability payable. Subject to this, the company has made a profit of 50,000 for the year.

Why do accountants do like that?

The reason lies in a concept called ‘matching principle’. Matching principle says – that appropriate costs should be matched to the sales for the period represented in the income statement. Knowledge of this concept is necessary to understand how accountants arrive at the profit of a business.

Let’s take another example. My business performs consulting service for a client and has billed Rs 50,000 in December 2010 and he pays my bill 3months later on April 2011. I do not have Rs 50,000 as my income because when I perform the service, I also incur some expenses in the form of salary, printing, electricity etc… Let’s assume that my expenses are Rs 15,000 in total. My profit for the year 2010 is Rs 35,000 and I have to pay tax for that amount- irrespective of the fact that my client has paid me Rs 50,000 in April 2011!!

This might seem to be strange for Newbies. Think and you’ll understand. If I don’t ‘match’ my expenses of 2010 to ‘revenues’ of 2010, my financial statements would never show the right picture in any year. It will show a loss of Rs 15,000 in 2010 and a profit of Rs 50,000 in 2011. Although I know the reason, nobody looking at my financial statement would be able to understand why I incurred a loss in one year and a huge profit in the next year.

The above is case a very simplified example. Imagine what would be the result when you have huge volume of bills and number branches all over India? Even I may not understand what has caused too much volatility.

The above discussion brings us to some realities-

  • The ‘sales’ or ‘revenues’ or ‘operating income’ you see in the income statement is the value of goods sold or services rendered in a particular year. For example – sale revenue of Rs 300 Crores means that the company has actually ‘sold’ or ‘rendered services’ worth Rs 300 Crores. It doesn’t mean that the company has received 300 Crores in their bank account. Some of the customers may have paid a portion of it.
  • The profit shown in the financial statements is based on the above sales figure of Rs. 300 Crores after deducting the expenses incurred. Let’s assume that the expenses (salary etc.) incurred by the company to generate Rs 300 Crores is Rs 140 Crores. The company has made a profit of Rs 160 Crores ‘in papers’. But in reality, since their clients have paid the whole amount, the profit that’s displayed at the end of the revenue statement is basically an estimate. ( we said that earlier in our post components of financial statements that profit is an estimate). The customers have not paid yet, so the profit shown in the statements does not reflect real money. So, a company can be very profitable and still run out of cash!!
  • Later, the profit shown in papers will turn into real cash when the customers start paying.
  • Let’s see one more application of the matching principle – If the company buys a truck in 2010 that it plans to use for 5 years, the full cost of the truck will not be shown as expense in 2010 itself. That’s because, the company is availing the benefit of the truck for the next 5 years and hence, the cost of the truck has to be spread over the next 5 years and should be deducted from the sale proceeds of these 5 years equally.
  • The profit and loss account, in fact, tries to measure whether the products or services that a company provides are profitable when each and every expense (whether paid or not) is considered. It has nothing to do with the company’s actual cash inflow and outflow.


CONCLUSION

That’s matching principle for you. Now we proceed to discuss about the components of income statement. There are basically only 5 components in an income statement. These are 1. sales 2. Direct expenses 3. Gross profit 4. Indirect expenses 5. Net profit. If there are only 5 components, then why does an income statement look very complicated with lots of figures in it? We’ll try to understand all that in our next lesson.

5 Comments