PBL Study blog: Trigger 7: Accounting terminology

1. What are the main components of an income statement?

Income statement (sometimes also called the profit and loss statement or statement of operations) is one of the three major financial statements. It is used to calculate the profitability of a company. There are two kinds if income statements: Single step and Multiple step. Let's have a look at some terminology one might come across while reading an income statement. (1)

Two main categories in a single step income statement are 1. Revenues and gains, and 2. Expenses and losses. These two categories will together form net income. The formula is below:

(1)

To be more specific, there are several sorts of revenue or income, as well as expenses and losses. Let's have a look at our exemplary income statement, step by step.

NET SALES means all sales the company has made, minus discounts, damaged or missing goods, allowances and returned goods. (2)

From net sales you then deduct EXPENSES which include:
Goods and services
In a café Expenses from goods and services would mean prices and delivery of the ingredients they use for their products.
Salary related expenses:
Salaries would obviously fall under this category, but also other expenses such as sick leaves, holidays, and employees' insurance.
Depreciation
Book keeping principles require that a company reports the yearly depreciation of their assets. Depreciation of an asset means this: A company buys an equipment, and evaluates that they can use it for 5 years. They first deduct the salvage value from the purchase price, then divide the remaining value for each year they expect to use the equipment. (3)
Operating expenses
Other operating expenses include things that have little to do with the products the company sells.
For a café this could mean, for example office supplies.
Other operating income
For example renting the premises for an event.

When all of the expenses above are deducted from the net sales, what remains under the line is called OPERATING INCOME.

In addition to operating income, a company can receive other income, for example financial income, which means things like income from municipal bonds, tax returns and interest from given loans. Financial expenses generally refer to interests of company's long term dept. (4)

After the financial income/expense has been added to/deducted from the operating income, what's left is called INCOME BEFORE TAXES. Taxes are calculated for this amount. In Finland the tax percentage for organizations is 20%. (5) This amount is called INCOME TAX EXPENSE.

Once the tax has been deducted, we finally get the NET INCOME. If the amount remaining on the bottom line is negative, it is referred to as NET LOSS.

This example was a single-step income statement. One major difference with a multiple-spet, or a multi-step income statement is that it shows the GROSS PROFIT, which means net sales- cost of sold goods. Multi-step income statement also would have adressed the categories in more detail, showing what kind of expenses fall under Salary related expenses, to give one example.

2. What are the main components of balance sheet?

One of the main financial statements. The balance sheet reports the assets, liabilities, and owner's (stockholders') equity at a specific point in time, such as December 31. The balance sheet is also referred to as the Statement of Financial Position.

Here's a brief video on how balance sheet works:
http://www.investopedia.com/video/play/introduction-balance-sheet/

Assets:

Things that a company owns. Also costs that have already been paid, but the service is still ongoing.

Non-current assets (something that has been there longer than a year)

For example machinery and supplies
-Intangible assets: immaterial rights, for example, patents, copy rights and such. (6)

Current assets (something that comes and goes)

-Materials and supplies

-Accounts receivables: a sale made with credit, where invoice is yet to be paid. Potential loss, is customer does not pay on time
-Other receivables, long term: Long term assets that are too insignificant to be listed separately.
-Prepaid expenses and An asset that has already been paid for, but not yet (fully) used (7)
-Accrued income: An adjustment made to a financial statement, where the actual income has not been received yet, but is market in books as debit. (7)(8)
-Other receivables, short-term: Short term assets that are too insignificant to be listed separately.

-Cash and petty cash: Cash is balance on an account, petty cash is actual, concrete cash.
-Investments and securities: Bonds or stock that company owns

Equity:

The difference between company's assets and liabilities. (11)

-Share capital: The amount of funding a company has raised by selling stock to public investors (12)
-Retained earnings: Amount of net earnings that is not paid out as dividends, but retained by the company to pay dept or to be reinvested in the business itself (13)
-Net Income: The bottom line of an income statement

Liabilities:

An obligation payable by the company, for example wages, loans, invoices and such.

-Loans from financial institutions: Loans company has taken and has not yet (fully) paid back

-Accounts payable: Invoices for goods or services the company has yet to pay

-Other liabilities: Liabilities that are too insignificant to be listed separately

-Accrued expenses: An expense that has yet to occur, such as a salary that's due to be paid in the future. (14)

-Unearned revenue: Services or good a company has not done yet, but has already received a payment for.

Total equity and liabilities:

Same as assets.

3. How to analyze income statement and balance sheet?

Evaluating BALANCE SHEET is important for shareholders and potential buyers, as it can reveal information about working capital adequacy, asset performance and capitalization structure. These three are categories of investment-quality measurements. (15)

I will briefly explain what these measurements mean:

Capitalization structure: What different sources of funds a company uses to finance its growth and overall operations. Most important measurement in capital structure is company's dept-to-equity ratio. Company with a greater percentage of dept can pose a greater risk for investors. (16)

Asset performance: A company's ability to turn resources into subsequent returns. Following metrics can be used to evaluate asset performance:
-cash conversion cycle
-return on assets ratio
-fixed asset turnover ratio

Improvement in asset ratio means that it can now produce higher proofits with same resources or, can produce same results with lesser resources. Asset performance, and changes in asset performance are an important consideration for investors. (17)

Working capital adequacy: Measures a company's short-term financial health and its efficiency. Is calculated as follows:

Working Capital = Current Assets - Current Liabilities

If this figure is negative, a company can run into trouble paying it's bills, which can lead to short or long term financial diffuculties, or even bankruptcy. (18)

When analyzing INCOME STATEMENT, it is most important to look at the profitability calculations:

Gross margin= Gross profit/sales
This calculation gives a percentage, but the plain number does not tell whether a company's gross margin is good or bad. To evaluate this, we need to also look at other profitability ratios, such as:

Operating margin= Operating profit/ sales

Pretacx margin= Pretax income/sales

Net income margin= Net income/sales

Here's an example of mentioned calculations:

Picture from Youtube video: Income Statement Analysis - Beginners Guide (19)

For example the Net income margin in this example would mean, that for every $1000 the company generates income, they get $33 as profit.

To determine whether the calculates ratios are good, the figures need to be compared to something.

The first comparison would be with other companies' figures in the same line of business. Different lines of business have different expextations of profitability, and thus there's not much use in looking at other industries for comparison.

It is also worth looking at how the profitability is changing over time in a company. Normally these figures are looked at for the period of past three years. It is also worh following the quarterly figures. If profitability is not consistent, or is going down, then there might be reason to worry.

One can also analyse the growth rate over time. If growth is slowing down, it might not be concerning in and of itself, but it definitely gives reason to look at other figures to see if there's something wrong. If at the same time gross margin would be going down, for example, then this could be a reason for concern, especially, if the same is not happening in other companies in the industry.

What is relevant in analyzating the income statement, is that all figures are interconnected, and don't really give any real information when looked at separately. (19)

References:
1. http://www.accountingcoach.com/income-statement/explanation/1
2. http://www.accountingcoach.com/terms/N/net-sales
3. http://www.accountingcoach.com/depreciation/explanation

PBL Study blog

maanantai 31. lokakuuta 2016

Trigger 7: Accounting terminology