Income (also referred to as earnings or profit) summarizes, in financial terms, the net effects of a business’s operations during a given time period. It is the most demanded piece of company information by the financial markets. Determining and explaining a business’s income for a period is the main purpose of the income statement. Conceptually, income purports to provide both a measure of the change in stockholders’ wealth during a period and an estimate of a business’s current profitability, that is, the extent to which the business is able to cover its costs of operations and earn a return for its shareholders. Understanding this dual role of income is important for analysis. In particular the latter role of income, that is, indicator of firm profitability, is of crucial importance to an analyst because it aids in estimating the future earning potential of the business, which arguably is one of the most important tasks in business analysis.
Accounting, or reported, income is different from economic income. This is because accountants use different criteria to determine income. To illustrate this point, consider a company with $100,000 in cash. This company uses the $100,000 to buy a condominium, which it rents out for $12,000 per year. At the end of the first year the
company still owns the condo, which is valued at $125,000. Let’s begin our analysis by determining various cash flow measures. Free cash flow for the year is $(88,000), while operating cash flow is $12,000. Does either of these measures indicate how much the shareholders earned during the period? No. For that we need to determine income. First, let us compute economic income. Economic income measures the change in shareholders’ wealth during a period. Obviously the $12,000 in rental income increased shareholders’ wealth. In addition, the condo appreciated by $25,000 during the year, which also increased shareholders’ wealth. Therefore, economic income for the year is $37,000 (rental income, $12,000, plus holding gain, $25,000). Accounting income, which is based on accrual accounting, depends on the depreciation policy for the condominium.Namely, if the condominium’s useful life is 50 years and its salvage value is $75,000, then yearly straight-line depreciation for the year is $500 [computed as ($100,000 $75,000) 50 years]. This yields an accounting income of $11,500 (rentalincome of $12,000 less $500 depreciation) for the year. This illustration shows that economic income differs from accounting income, and both differ from the cash flow measures.
We might also notice that the $37,000 economic income is probably not sustainable. That is, we can’t count on a 25% annual appreciation in the condominium’s value year after year. This implies the economic income of $37,000 is less useful for forecasting future earnings. Accounting income of $11,500 at least in this case is probably closer to permanent or sustainable income, which would help us estimate future earnings. However, while the $25,000 holding gain cannot be sustained, note that it is not entirely useless for forecasting future income; if the $25,000 increase in the condo value is permanent (i.e., the condominium value is not expected to immediately revert back to $100,000), then it is reasonable to assume that returns from owning the condo (i.e., rental income) might increase in the future.
Understanding alternative income concepts and relating these concepts to accounting income is helpful in business analysis. A major task in financial statement analysis is evaluating and making necessary adjustments to income
Accounting, or reported, income is different from economic income. This is because accountants use different criteria to determine income. To illustrate this point, consider a company with $100,000 in cash. This company uses the $100,000 to buy a condominium, which it rents out for $12,000 per year. At the end of the first year the
company still owns the condo, which is valued at $125,000. Let’s begin our analysis by determining various cash flow measures. Free cash flow for the year is $(88,000), while operating cash flow is $12,000. Does either of these measures indicate how much the shareholders earned during the period? No. For that we need to determine income. First, let us compute economic income. Economic income measures the change in shareholders’ wealth during a period. Obviously the $12,000 in rental income increased shareholders’ wealth. In addition, the condo appreciated by $25,000 during the year, which also increased shareholders’ wealth. Therefore, economic income for the year is $37,000 (rental income, $12,000, plus holding gain, $25,000). Accounting income, which is based on accrual accounting, depends on the depreciation policy for the condominium.Namely, if the condominium’s useful life is 50 years and its salvage value is $75,000, then yearly straight-line depreciation for the year is $500 [computed as ($100,000 $75,000) 50 years]. This yields an accounting income of $11,500 (rentalincome of $12,000 less $500 depreciation) for the year. This illustration shows that economic income differs from accounting income, and both differ from the cash flow measures.
We might also notice that the $37,000 economic income is probably not sustainable. That is, we can’t count on a 25% annual appreciation in the condominium’s value year after year. This implies the economic income of $37,000 is less useful for forecasting future earnings. Accounting income of $11,500 at least in this case is probably closer to permanent or sustainable income, which would help us estimate future earnings. However, while the $25,000 holding gain cannot be sustained, note that it is not entirely useless for forecasting future income; if the $25,000 increase in the condo value is permanent (i.e., the condominium value is not expected to immediately revert back to $100,000), then it is reasonable to assume that returns from owning the condo (i.e., rental income) might increase in the future.
Understanding alternative income concepts and relating these concepts to accounting income is helpful in business analysis. A major task in financial statement analysis is evaluating and making necessary adjustments to income
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