Wednesday, 14 April 2010

A Look at Financial Statements: Income Statement

We have looked at accounting procedures and principles and now we will look at typical financial statements that are the final outputs from the accounting system. We start with the Income Statement. The objective is to provide a general idea of how published income statements look like, and what each item in these statements signify,

A standard income statement as published by U.S. companies is illustrated to the right. You can click on the statement to get a larger and readable view that will open in a separate window. The statement conforms to rules laid down by Financial Accounting Standards Board for published Income statements.

The Income Statement summarizes the revenue and expenses during the period indicated in the statement. It is thus a report on the performance of the company viz. how much revenue the company was able to generate and the level of expenses incurred for generating that income.

As we mentioned in the last post, financial statements are mainly for external users, such as investors, lenders, governments and the public. For Internal use, there is a separate management information system that generates very different types of information, which we will look at later.

Let us now look at each item in the statement and try to understand what they mean.

At the very top is an indicator of the periods for which the statement relates to. There are six columns and several rows in the statement. The top row is the heading indicating the nature of items in each column:

  1. The first column is a description column that briefly indicates the nature of the items.
  2. Against each description, corresponding values are shown in five columns. Each column shows the total income or expense for a 52 week period ending on the date shown in the top row of that column. Comparable amounts for several years allow us to see how well the company has been growing. (Though this example shows comparable amounts for five years, published statements typically show only the previous year amounts for comparison.)
  3. The statement proper starts with the Revenue earned in each of the periods. Revenue represents such income items as sales of merchandise and fees earned for any services rendered. Revenue performance reflects the effectiveness of the company's marketing efforts.
  4. Cost of Revenue represents the direct costs of producing the merchandise or rendering the service. It includes such items as raw materials and the time spent by service providers that are directly identifiable to the merchandise or service.
  5. Revenue minus Cost of Revenue is the "Gross Profit" made by the company. Broadly, this is the margin over direct costs. It is this margin that meets the indirect costs of carrying on the business, and generates a surplus profit.
  6. The rows that follow list various expenses that are NOT directly identifiable with merchandise or service. These include such items as office salaries, building rentals, and other "establishment" expenses. Also included are marketing and financial expenses, such as salesperson salaries, advertisements and interest payments.
  7. The total of the operating expenses is deducted from gross profit to arrive at the Operating Income. This is what the company has earned in the normal course of its business.
  8. There could be non-operating income or expenses, such as sales of "fixed" assets which are not meant for resale in the course of business (unlike merchandise). The net amount of such non-operating items is adjusted against the operating income to arrive at Taxable Income (Income before Tax).
  9. Tax is computed under prevailing income tax laws and shown next.
  10. Deducting the tax from the income, we get the Income after Tax, which is what shareholders are entitled to.
  11. Some adjustments need to be made to this income amount to comply with government regulations regarding disclosure of information in published financial statements. These include any adjustments needed to conform with U.S. GAAP (Generally Accepted Accounting Principles) and deduction of the share of profit of minority shareholders in subsidiary companies, i.e. companies in which our company holds majority of shares but not 100%.
  12. The amount remaining after the adjustments is the ordinary income. From this is deducted or added any extraordinary items that are unrelated to the business, such as the costs incurred in connection with a tornado that damaged the company's plant.

The final amount arrived at as above is what can be distributed as dividend to shareholders of the company. It might not be so distributed, in full or in part, if the company needs funds to expand operations or for other reasons. 

By analyzing the income statement, a lot of information about the company's operations can be gleaned. We will look at how the analysis is done in the next post.

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