The Income Statement
The income statement is a summary of the profitability of the firm over a period of time, such as a year. It presents revenues generated during the operating period, the expenses incurred during that same period, and the company’s net earnings or profits, which are simply the difference between revenues and expenses. It is useful to distinguish among four broad classes of expenses: cost of goods sold, which is the direct cost attributable to producing the product sold by the firm; general and administrative expenses, which correspond to overhead expenses, salaries, advertising, and other costs of operating the firm that are not directly attributable to production; interest expense on the firm’s debt; and taxes on earnings owed to federal and local governments.
Table 14.1 presents an income statement for Home Depot (HD). At the top are the company’s revenues. Next come operating expenses, the costs incurred in the course of generatingthese revenues, including a depreciation allowance. The difference between operating revenues and operating costs is called operating income. Income (or expenses) from other, primarily nonrecurring, sources is then added to obtain earnings before interest and taxes (EBIT), which is what the firm would have earned if not for obligations to its creditors and the tax authorities. EBIT is a measure of the profitability of the firm’s operations abstracting from any interest burden attributable to debt financing. The income statement then goes on to subtract net interest expense from EBIT to arrive at taxable income. Finally, the income tax due the government is subtracted to arrive at net income, the “bottom line” of the income statement.
Analysts also commonly prepare a common-size income statement, in which all items on the income statement are expressed as a fraction of total revenue. This makes it easier to compare firms of different sizes. The right-hand column of Table 14.1 is HD’s common-size income statement.
The income statement is a summary of the profitability of the firm over a period of time, such as a year. It presents revenues generated during the operating period, the expenses incurred during that same period, and the company’s net earnings or profits, which are simply the difference between revenues and expenses. It is useful to distinguish among four broad classes of expenses: cost of goods sold, which is the direct cost attributable to producing the product sold by the firm; general and administrative expenses, which correspond to overhead expenses, salaries, advertising, and other costs of operating the firm that are not directly attributable to production; interest expense on the firm’s debt; and taxes on earnings owed to federal and local governments.
Table 14.1 presents an income statement for Home Depot (HD). At the top are the company’s revenues. Next come operating expenses, the costs incurred in the course of generatingthese revenues, including a depreciation allowance. The difference between operating revenues and operating costs is called operating income. Income (or expenses) from other, primarily nonrecurring, sources is then added to obtain earnings before interest and taxes (EBIT), which is what the firm would have earned if not for obligations to its creditors and the tax authorities. EBIT is a measure of the profitability of the firm’s operations abstracting from any interest burden attributable to debt financing. The income statement then goes on to subtract net interest expense from EBIT to arrive at taxable income. Finally, the income tax due the government is subtracted to arrive at net income, the “bottom line” of the income statement.
Analysts also commonly prepare a common-size income statement, in which all items on the income statement are expressed as a fraction of total revenue. This makes it easier to compare firms of different sizes. The right-hand column of Table 14.1 is HD’s common-size income statement.
the productive capacity of the firm. In contrast, accounting earnings are affected by several conventions regarding the valuation of assets such as inventories (e.g., LIFO versus FIFO treatment) and by the way some expenditures such as capital investments are recognized over time (as depreciation expenses). We will discuss problems with some of these accounting conventions in greater detail later in the chapter. In addition to these accounting issues, as the firm makes its way through the business cycle, its earnings will rise above or fall below the trend line that might more accurately reflect sustainable economic earnings. This introduces an added complication in interpreting net income figures. One might wonder how closely accounting earnings approximate economic earnings and, correspondingly, how useful accounting data might be to investors attempting to value the firm. In fact, the net income figure on the firm’s income statement does convey considerable information concerning a firm’s products. We see this in the fact that stock prices tend to increase when firms announce earnings greater than market analysts or investors had anticipated.
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