Reading Financial Reports for Dummies (19 page)

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Sales or revenues:
How much money the business took in from its sales to customers.

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Cost of goods sold:
What it cost the company to produce or purchase the goods it sold.

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Expenses:
How much the company spent on advertising, administration, rent, salaries, and everything else that’s involved in operating a business to support the sales process.

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Net income or loss:
The bottom line that tells you whether the company made a profit or operated at a loss.

The income statement is one of the three reports required by the Securities and Exchange Commission (SEC) and the Financial Accounting Standards Board (FASB); I describe their roles in the preparation of financial statements in Chapters 18 and 19. In fact, the FASB specifies that the income statement provide a report of comprehensive income, which means the report should reflect any changes to a company’s equity during a given period of time that are caused by transactions, events, or other circumstances involving transactions with nonowner sources. In simpler terms, any changes in equity that aren’t raised by investments from owners or distributed to owners must be reflected on this statement.

When looking at an income statement, you can expect to find a report of either

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Excess of revenues over expenses:
This report means the company earned a profit.

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Excess of expenses over revenues:
This report means the company faced a loss.

Because the income statement shows profits and losses, some people like to call it the profit and loss statement (or P&L), but that isn’t actually one of its official names. In addition to “statement of income,” the income statement has a number of official names that you may find in a financial report. These include

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Statement of operations

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Statement of earnings

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Statement of operating results

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Digging into dates

Income statements reflect an
operating period,
which means that they show results for a specific length of time. At the top of an income statement, you see the phrase “Years Ended” or “Fiscal Years Ended” and the month the period ended for an annual financial statement. You may also see “Quarters Ended” or “Months Ended” for reports based on shorter periods of time.

Companies are required to show at least three periods of data on their income statements, so if you’re looking at a statement for 2008, you also find columns for 2007 and 2006.

Many people believe you should analyze at least five years’ worth of data if you’re thinking about investing in a company. You can easily get hold of this data by ordering a two-year-old annual report along with the current one. You can also find most annual and quarterly reports online at a company’s Web site or by visiting the SEC’s Edgar Web site (www.sec.gov/edgar.shtml), which posts all financial reports filed with the SEC. Because each report must have three years’ worth of data, a 2008 report will show data for 2007 and 2006, too. And a 2005 report will show 2004 and 2003 data also. So you’ll actually have six years’ worth of data: 2008, 2007, 2006, 2005, 2004, and 2003.

Figuring out format

Not all income statements look alike. Basically, companies can choose to use one of two formats for the income statement: the single-step or the multistep.

Both formats give you the same bottom-line information. The key difference between them is whether they summarize that information to make analyzing it easier. The single-step format is easier to produce, but the multistep format gives you a number of subtotals throughout the statement that make analyzing a company’s results easier. Most public corporations use the multistep format, but many smaller companies that don’t have to report to the general public use the single-step format.

Single-step format

The
single-step format
groups all data into two categories: revenue and expenses. Revenue includes income from sales, interest income, and gains from sales of equipment. It also includes income that a company raises from its regular operations or from one-time transactions, such as from the sale of a building. Expenses include all the costs that are involved in bringing in the revenue.

The single-step format (see Figure 7-1) gets its name because you perform only one step to figure out a company’s net income — you subtract the expenses from the revenue.

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Revenues

Sales

$1,000

Interest income

200

Total Revenue

$1,200

Expenses

Cost of goods sold

$ 500

Depreciation

50

Advertising

50

Salaries and wages

100

Insurance

50

Research and development

100

Supplies

50

Interest expense

50

Income taxes

50

Figure 7-1:

Total Expenses

$1,000

The single-

step format.

Net Income

$ 200

Multistep format

The
multistep format
divides the income statement into several sections and gives the reader some critical subtotals that make analyzing the data much easier and quicker. Even though the single-step and multistep income statements include the same revenue and expense information, they group the information differently. The key difference is that the multistep format has the following four profit lines:

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Gross profit:
This
reflects the profit generated from sales minus the cost of the goods sold.

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Income from operations:
This
reflects the operating income earned by the company after all its operating expenses have been subtracted.

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Income before taxes:
This
reflects all income earned — which can include gains on equipment sales, interest revenue, and other revenue not generated by sales — before taxes or interest expenses are subtracted.

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Net income (or Net loss):
This
reflects the bottom line — whether or not the company made a profit.

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Many companies add even more profit lines, like earnings before interest, taxes, depreciation, and amortization, known as EBITDA for short (see the section “EBITDA” later in this chapter).

Some companies that have discontinued operations include those in the line item for continuing operations. But it’s better for the financial report reader if that information is on a separate line; otherwise, the reader won’t know what the actual profit or loss is from continuing operations. I delve a bit deeper into these various profit lines in “Sorting Out the Profit and Loss Types,” later in this chapter.

Figure 7-2 shows the multistep format, using the same items as in the single-step format example (refer to Figure 7-1).

Revenues

Sales

$1000

Cost of goods sold

$ 500

Gross Profits

$ 500

Operating Expenses

Advertising

50

Salaries and wages

100

Insurance

50

Research and development

100

Supplies

50

Operating Income

$ 150

Other Income

Interest income

200

Other Expenses

Interest expense

50

Depreciation

50

Income before Taxes

$ 250

Figure 7-2:

The multi-

Income taxes

50

step format.

Net Income

$ 200

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Delving into the Tricky

Business of Revenues

You may think that figuring out when to count something as revenue is a relatively simple procedure. Well, forget that. Revenue acknowledgement is one of the most complex issues on the income statement. In fact, you may have noticed that with the recent corporation scandals, the most common reason companies have gotten into trouble has to do with the issue of misstated revenues.

In this section, I define revenue and explain the three line items that make up the revenue portion of the income statement: sales, cost of goods sold, and gross profit.

Defining revenue

When a company recognizes something as revenue, it doesn’t always mean that cash changed hands, nor does it always mean that a product was even delivered. Accrual accounting leaves room for deciding when revenue is actually recorded. A company recognizes revenue when it earns it and recognizes expenses when it incurs them, without regard to whether cash changes hands. You can find out more about accounting basics in Chapter 4.

Because accrual accounting doesn’t require that a company actually have the cash in hand to count something as revenue, senior managers can play games to make the bottom line look the way they want it to look by either counting or not counting income. Sometimes they acknowledge more income than they should to improve the financial reports; other times they reduce income to reduce the tax bite. I talk more about these shenanigans in Chapter 23.

When a company wants to count something as revenue, several factors can make that decision rather muddy, leaving questions about whether a particular sale should be counted:

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If the seller and buyer haven’t agreed on the final price for the merchandise and service, the seller can’t count the revenue collected.

For example, when a company is in the middle of negotiating a contract for a sale of a major item such as a car or appliance, it can’t include that sale as revenue until the final price has been set and a contract obligat-ing the buyer is in place.

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If the buyer doesn’t pay for the merchandise until the company resells
it to a retail outlet (which may be the case for a company that works
with a distributor) or to the customer, the company can’t count the
revenue until the sale to the customer is final.

For example, publishers frequently allow bookstores to return unsold books within a certain amount of time. If there’s a good chance that some portion of the product may be returned unsold, companies must take this into account when reporting revenues. For instance, a publisher uses historical data to estimate what percentage of books will be returned and adjusts sales downward to reflect those likely returns.

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If the buyer and seller are related, revenue isn’t acknowledged in the
same way.

No, I’m not talking about kissing cousins here. I’m talking about when the buyer is the parent company or subsidiary of the seller. In that case, companies must handle the transaction as an internal transfer of assets.

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If the buyer isn’t obligated to pay for the merchandise because it’s
stolen or physically destroyed before it’s delivered or sold, the
company can’t acknowledge the revenue until the merchandise is
actually sold.

For example, a toy company works with a distributor or other middleman to get its toys into retail stores. If the middleman doesn’t have to pay for those toys until they’re delivered or sold to retailers, the manufacturer can’t count the toys it shipped to the middleman as revenue until the middleman completes the sale.

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If the seller is obligated to provide significant services to the buyer
or aid in reselling the product, the seller can’t count the sale of that
product as revenue until the sale is actually completed with the final
customer.

For example, many manufacturers of technical products offer installation or follow-up services for a new product as part of the sales promotion. If those services are a significant part of the final sale, the manufacturer can’t count that sale as revenue until the installation or service has been completed with the customer. Items shipped for sale to local retailers under these conditions wouldn’t be considered sold, so they can’t be counted as revenue.

Adjusting sales

Not all products sell for their list price. Companies frequently use discounts, returns, or allowances to reduce the prices of products or services.

Whenever a firm sells a product at a discount, it should keep track of those 98
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discounts, as well as its returns and allowances. That’s the only way the company can truly analyze how much money it’s making on the sale of its products and how accurately it’s pricing the products to sell in the marketplace.

If a company must offer too many discounts, that’s usually a sign of a weak or very competitive market. If a company has a lot of returns, that may be a sign of a quality-control problem or a sign that the product isn’t living up to customers’ expectations. The sales adjustments I talk about here help a company track and analyze its sales and recognize any negative trends.

As a financial report reader, you won’t see the specifics about discounts in the income statement, but you may find some mention of significant discounting in the notes to the financial statements. The most common types of adjustments companies make to their sales are

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Volume discounts:
To get more items in the marketplace, manufacturers offer major retailers
volume discounts,
which means these retailers agree to buy a large number of a manufacturer’s product in order to save a certain percentage of money off the price. One of the reasons you get such good prices at discount sellers like Wal-Mart and Target is because they buy products from the manufacturer at greatly discounted prices. Because they purchase for thousands of stores, they can buy a very large number of goods at one time. Volume discounts reduce the revenue of the company that gives them.