Introduction to Financial Statements – Income Statement
3 Ways to Learn:
- Watch the video
- Read the transcript (below the video)
- Download the free eBook
- 1 – Introduction to The Income Statement
- 2 – Beginning Income Statement Analysis
- 3 – Introduction to the Balance Sheet
- 4 – Beginning Balance Sheet Analysis
- 5 – Introduction to the Cash Flow Statement
- Download eBook and Excel Spreadsheet
CREDIT MANAGER SEMINARS
Over the years, I have done dozens of training seminars for credit industry groups, including seminars sponsored by Dun & Bradstreet, the National Association of Credit Management and Riemer Reporting Services. I have adapted those presentations into this video series. On occasion I will highlight information from the perspective of credit management, but in general the information applies to anyone interested in understanding and analyzing financial statements. I hope you find this helpful.
Transcript for the video:
3 FINANCIAL STATEMENTS
In this introduction to financial statement series , we are providing a simple, basic overview of financial statements and how to analyze them. While we will not get into accounting rules or extensive detail on any item, these videos provide a complete high-level explanation of each financial statement and some simple methods to analyze the financial statements. In this first video, we explain what the income statement is and the information that is presented on it. In the next video, we explain how to analyze the income statement. The information presented in these videos is also available in a free download, which includes definitions of most terms mentioned in these presentations.
STATEMENT OF PROFITABILITY
The income statement is the statement of the company’s profitability during a specific period of time. That period of time may be a month, a quarter, or a year. Profitability is not the same as cash flow which may be more important for credit managers assessing the credit risk of a potential customer. While profitability is important, it is not the only factor to consider when evaluating credit risk. Accounting rules determine how items should be recorded in the financial statements but we will not be getting into the rules in this introductory series.
At the top of the income statement, the first thing you will notice is that it tells you what period the information is for, typically a month, a quarter, or a year. The other key thing at the top of the income statement is to tell you whether the amounts shown are actual dollars, down to the penny, or whether these are truncated numbers. For example, when it says 000’s that means we’ve left off three zeros. Another way is to show that is to have the word ‘thousands’ or even ‘millions’. So a number that says 11892 and there’s nothing here, then that means $11,892. But in this example, the three zeros indicate that the numbers shown are in thousands. Therefore the 11892 stands for $11 million 892 thousand dollars. If it said millions then it would stand for $11 billion, 892 million dollars—and yes, there are some companies with numbers that big.
SALES AND GROSS PROFIT
The first item to be reported on the income statement is typically revenue or sales. Next comes cost of goods sold. This is the direct cost of making the products that were sold to generate the revenue reported on the income statement. For example, if this company is a manufacturer of coffee cups, the cost of goods sold represents the amount of money to make all of the cups that were then sold to generate the $11,892,000 in revenue. This would include the raw materials and the labor that was required to make the cups as well as all of the packaging material, but not items like advertising expenses. When you subtract the cost of goods sold from sales, that gives you what is called the gross profit. This is a very important number because this is the profitability before all of the overhead, and the higher the gross profit, the more profitable the business can be.
The next section of the income statement is the operating expenses. These are the expenses that the company incurred in order to generate revenue, as well as costs related to investing for future sales. Accounting rules require that operating expenses be divided up into three categories: research and development, selling expense, and general and administrative overhead. Costs incurred to develop the current products as well as new and potential future products are recorded in the research and development category, which often is referred to as R&D. Selling expenses include marketing and advertising costs plus sales people and customer service expenses. General and administrative expenses include expenses for departments such as human resources, legal, and finance. For this company, total operating expenses were $1,235,000. We then subtract the operating expenses from the gross profit, and that gives us the operating profit. This is one of the most important items in measuring the company’s profitability.
Non-operating income and expenses are items that effect overall profitability but aren’t related to the operations of the business. The easiest example is interest income. When the company has extra money available it keeps it in the bank and it earns interest. The amount of interest a company earns has nothing to do with its sales, cost of goods sold, or operations. Therefore, it is a non-operating item. The same can be said for interest expense on any money that the company has borrowed. While this is an expense, and it negatively impacts profitability, it doesn’t have anything to do with operations of the business. It has to do with how the business was financed. Other income is a catch-all for all other non-operating income, while temporary changes in the value of assets is also reflected in this section. The non-operating income is added to the operating profit number to arrive at pretax income. If non-operating income is actually a loss, this will show as a negative number on the income statement, and when that negative number is added to the operating profit, it results a smaller amount shown as pretax income.
In the final section of the income statement, we adjust pretax income for other items such as income taxes and extraordinary items. Accounting rules are very specific on what items should be recorded as extraordinary items instead of in operating or non-operating categories. Net Income is calculated by subtracting income taxes from pretax income and adding or subtracting extraordinary items. So in this example, this company made $397,000 during the prior year on sales of $11.9 million.
The next video in this series is Beginning Income Statement Analysis. Remember, you can download the Financial Statement Analysis eBook, which includes over 50 definitions and ratio calculations. It also includes an Excel spreadsheet that will calculate key ratios when you input financial data. If you need debt collection assistance, we are specialists in large business-to-business claims, and we can refer you to other agencies if your needs do not fit with our expertise. Just fill out the Request A Quote form or give us a call.
Our commercial debt collectors are trained to examine income statements to understand the reasons behind non-payment. If we see a company is profitable, this gives us leverage when demanding payment as the business has no valid reason for not paying. However, we often encounter income statements showing a loss. When this is the case, our focus turns to understanding the causes of this loss: low gross margins, high fixed operating costs, etc. Once we understand the challenges facing your debtor, we’re far better equipped to resolve the problem. This understanding of financial statement analysis is what sets our debt collectors apart from other agencies, and allows us to provide superior results for our clients.