WEBVTT

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I figure now is as good a time
as any to learn about probably

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what most people focus the
most on when they analyze

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companies, and that's the
income statement.

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And the income statement is
one of the three financial

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statements that you'll look at
when you look at a company.

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There's the income statement
and the other two are the

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balance sheet, which I have
drawn a lot in a lot of the

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other explanations I've done
on the financial crisis and

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whatever else.

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And actually, in this video,
we're going to see how the

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income statement relates
to the balance sheet.

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And, of course, the last one--
well, it's not of course if

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you don't know it-- is the
cash flow statement.

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And we'll focus on that a
little bit later because

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that's a little bit more
nuanced relative

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to the income statement.

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So the income statement is
literally just saying how much

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a company might earn in a given
period, and it's always

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related to a period.

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So it could be an annual
income statement.

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It could be for the year 2008.

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It could be a quarterly
income statement.

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Those are usually the two
types that you see, but

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sometimes, there's monthly or
six-month income statements.

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And the general format is pretty
consistent, although

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there is a lot of variation
depending on what a business

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does, but in this video, I
really just want to cover

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almost a plain vanilla income
statement for a company that

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just sells a widget.

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So the first thing when you sell
a widget is you make it

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and you just sell it.

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You sell the widget.

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You give a customer a widget,
and they give you some money.

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And that money that they give
you-- and I'm not going to get

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too technical about the
accounting right now-- is

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considered revenue.

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It's sometimes considered
sales.

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And that's literally the money
that they give you at a

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certain period of time.

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And some of you accountants out
there are like, oh, well,

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no, that's not just the money
that they give you.

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It's the money that you've
earned in a certain period of

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time, and that's true.

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But for our sake, let's just
say that when you give the

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widget, you have earned the
money that they give you, and

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that's revenue sales.

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Later on, we'll talk about
different ways to account

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revenue and sales.

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So let's say the revenue or the
sales in this case in a

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given period, let's say
that this is an income

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statement for 2008.

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So over 2008, we sold
let's say $3

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million worth of widgets.

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So let's say it's $3 million.

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And a lot of times when you look
at income statements for

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companies, if you go to Yahoo!

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Finance, you could do this right
now, instead of writing

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$3 million, you'll
see $3,000 there.

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It's like, oh, my God!

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This company, they're hardly
selling anything.

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But it's kind of a standard that
they tend to write things

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in thousands.

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So 3,000 would be
3,000 thousands,

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which would be 3 million.

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And for really big companies,
they actually sometimes write

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their numbers in millions.

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So if you saw 3,000 there, it
would actually mean 3 billion.

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But we'll actually look at real
income statements in the

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not-too-far-off future.

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So that's how much money
they give us.

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But that's not how much income
we made, because there was a

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lot of cost that went into
making that widget that we

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have to account for.

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It's not like when someone gives
me $3 million, I can

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just say, oh, I made
$3 million.

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Let me just put it
all in the bank.

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I'm done.

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That was all income.

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So the first thing that you
tend to see on an income

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statement is the cost of those
actual widgets, the cost of

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producing those widgets.

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And I'll put all my expenses
in magenta.

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So it'll sometimes be written
as cost of sales or cost of

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goods sold.

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And this is literally-- well,
there's two things.

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There's a variable cost which
is, each widget, they might

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have used some amount of metal
and some amount of energy to

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produce it and some
amount of paint if

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it's a painted widget.

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And so that the cost of goods
is literally how much did it

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cost to buy the metal and the
paint and provide the

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electricity to make those $3
million worth of widgets.

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That's the variable cost. And
then on top of that you have

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the fixed costs, or the
relatively fixed costs, where

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just to have the factory open,
it costs a certain amount of

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money every year, regardless of
how many widgets you make.

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And we'll go into more detail
on that, But for simplicity,

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let's say all those costs
of making the

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widgets were $1 million.

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So sometimes someone might say
it's a $1 million cost. When I

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make models, I like to put
a minus there, so that I

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remember that that's a cost.
Anything that detracts from

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income I put as a minus.

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Anything that adds is a plus,
although that's not

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necessarily the standard
convention.

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Some people say, oh, it's a
positive $1 million cost,

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which means you subtract.

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But either way I think
you get the point.

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And then if you subtract your
costs from your revenue, or if

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you just add these two numbers,
because this one is

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negative, you have your
gross profit.

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And in this case, it would
be $2 million.

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And this number tells you, how
much money did you make, or

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how much profit did
you make just from

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selling these widgets?

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So the more widgets you sell,
in most circumstances, the

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larger this number
is going to be.

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So this is your profit before
all of the other expenses that

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a company has to incur,
like the taxes

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and the CEO's salary.

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The CEO's salary doesn't
go in here, right?

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Because the CEO doesn't go out
there to the factory in most

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cases and actually help
make the widget.

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So the CEO's salary or the
CFO's salary or the

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headquarters in a nice
skyscraper, that doesn't get

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factored in here.

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Or the marketing
expense, right?

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You have to tell people, hey,
we make good widgets.

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So none of that is
factored in here.

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So that goes into
the next line.

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And oftentimes, you'll see it
broken up, where they'll have

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marketing expense.

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Sometimes you have to pay
salespeople, so you might have

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sales expense, and then the
stuff like the corporate

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office and the CEO's salary, and
you have to hire auditors

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and accountants and
all of that.

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That might be included
as general.

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Actually, I should be doing this
in magenta because it's

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all expenses.

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Marketing, sales, and then
G&A you'll sometimes see.

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Sometimes you'll see SG&A.

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G&A just stands for general and
administrative expenses.

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If you see SG&A-- sometimes
instead of that you'll see

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SG&A-- that mean selling,
general and

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administrative expenses.

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Selling is things like, it could
be the commissions that

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the salespeople get.

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It could be just the cost of
having salespeople travel

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around the country and taking
people out to steak dinners.

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And then the general and
administrative, that's just

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all the stuff that the corporate
office does, and all

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the people who are
at that level.

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So if you subtract these, and
I'm just making up these

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numbers as I go.

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Say, in marketing, the company
is spending $500,000.

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And I'm putting it as a minus
because I like to remember

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it's an expense.

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Some models you'll
see, they'll say

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it's $500,000 expense.

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Sales, let's say, this
is just G&A here.

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I want to make a separate
line for sales.

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So let's say sales, selling
expenses is $200,000.

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And let's say G&A, the corporate
offices and all of

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that, let's see that's
another $300,000.

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And now we're ready to figure
out how much money did the

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operations of this
business make?

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So this is operating profit.

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This is really important to pay
attention to, because so

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many people say, oh, a company
made this much.

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And you'll hear these numbers,
gross and operating profit and

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net profit and pretax profit,
and it's very hard to

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understand that these are
actually very, very different

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things, because they all have
the word "profit," and what

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does gross and operating
and all that mean?

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But here you see it means very,
very different things.

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Let's calculate this number
first before I go off on one

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of my tangents on all the
differences between the

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operating and the
gross profit.

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But let's see, 2 million
minus 1 million.

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My head I think implicitly
made the

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numbers work out nicely.

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So my operating profit
here is $1 million.

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So already we have some
new nuance on profit.

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I made $2 million just from
actual widget sales, but then

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when you take out all of the
overhead of the company, the

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marketing, the sales, the
general and administrative

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expenses, I'm only left
with $1 million.

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And this is the profit from the
operations of the company,

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or you could say from the assets
or from the business or

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from the enterprise
of the company.

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That's what it is generating.

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But we can see-- I've drawn a
bunch of balance sheets before

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and I think this is a good time
to draw a balance sheet.

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So you have kind of the
assets of a company.

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And we'll talk a little bit
more about assets and

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enterprise value, and there's
a little bit of a nuance

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there, but essentially
the company itself.

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Before you think about how the
company is paid for or how

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it's funded, if you just think
about the enterprise itself,

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the assets.

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The assets are generating
this.

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They're generating the operating
profit, and that's a

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very important thing to realize
in the future when we

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talk about return on assets.

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Actually, we could talk
about it now.

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Let's say our assets, if we
paid $10 million for these

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assets, and these assets-- this
is the income statement

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for 2008-- are spitting out $1
million a year, or at least $1

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million in this year, our return
on asset-- I wasn't

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planning on introducing this,
but it doesn't hurt to

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introduce it right now-- our
return on asset, often

00:09:47.450 --> 00:09:53.530
acronymed ROA, would be-- well,
the numerator is the

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return, which is $1 million.

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The denominator is the
assets, $10 million.

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So we got a 10% return
on our assets.

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For a $10 million investment,
we're getting

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$1 million a year.

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We're getting 10% of our asset
investment back every year.

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So that's a nice thing to keep
in the back of your mind, this

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return on asset concept, and
it's very closely tied to

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operating profits and the
actual assets of a firm.

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What we've learned, and
especially if you watched some

00:10:23.970 --> 00:10:26.880
of my other economics videos,
that all companies aren't

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financed the same.

00:10:28.430 --> 00:10:30.040
A lot of them might
have some debt.

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So let's say that company had
$10 million of assets, but

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let's say they paid for it
with $5 million of debt.

00:10:37.380 --> 00:10:40.500


00:10:40.500 --> 00:10:45.370
And let's say the interest rate
on that debt is-- let me

00:10:45.370 --> 00:10:50.595
think of a good number-- 5%.

00:10:50.595 --> 00:10:57.670


00:10:57.670 --> 00:10:58.190
Let's make it easier.

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Let's make it 10% interest.

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So this is the operating
profit.

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This is the money that just
comes out of the asset itself.

00:11:04.790 --> 00:11:06.980
But, of course, that's not the
money that we get to take

00:11:06.980 --> 00:11:09.090
home, because we have to pay
this interest. So let's throw

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that in there as an expense.

00:11:10.340 --> 00:11:13.475


00:11:13.475 --> 00:11:14.320
Interest expense.

00:11:14.320 --> 00:11:16.350
And obviously, a company that
has no debt will have no

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interest expense, but
in this case, we do.

00:11:18.540 --> 00:11:21.350
And this is an annual
income statement.

00:11:21.350 --> 00:11:24.990
So let's see, if we have $5
million of debt, and we're

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paying 10% on that, 10% of $5
million is $500,000 a year in

00:11:30.240 --> 00:11:33.970
interest. So we have to
essentially take half of our

00:11:33.970 --> 00:11:38.660
operating profit and give
it back to the bank.

00:11:38.660 --> 00:11:43.150
And now we are left with our--
we're getting close to where

00:11:43.150 --> 00:11:46.650
we need to get to--
pre-tax income.

00:11:46.650 --> 00:11:51.370


00:11:51.370 --> 00:11:58.060
And if we do the subtraction,
we're at $500,000.

00:11:58.060 --> 00:11:59.950
And you could guess what the
next line is going to be,

00:11:59.950 --> 00:12:01.290
given that this says pre-tax.

00:12:01.290 --> 00:12:04.770
This is what the owners of the
company get before they pay

00:12:04.770 --> 00:12:06.510
the government.

00:12:06.510 --> 00:12:07.875
So you can guess what
the next line is.

00:12:07.875 --> 00:12:09.125
It's going to be taxes.

00:12:09.125 --> 00:12:11.500


00:12:11.500 --> 00:12:15.760
Let's say that it's a 30%
corporate tax rate, and you're

00:12:15.760 --> 00:12:19.020
going to take 30% of this
number right here.

00:12:19.020 --> 00:12:20.520
30% of that number
right there.

00:12:20.520 --> 00:12:28.580
So 30% of $500,000
is $150,000.

00:12:28.580 --> 00:12:30.060
And then we are done.

00:12:30.060 --> 00:12:33.020
We finally have paid off
everybody we need to pay off.

00:12:33.020 --> 00:12:36.060
So we started off with
$3 million up here.

00:12:36.060 --> 00:12:39.500
We kept paying a bunch of
expenses, and then now we're

00:12:39.500 --> 00:12:40.650
left with what?

00:12:40.650 --> 00:12:48.610
This is $350,000
of net income.

00:12:48.610 --> 00:12:51.370


00:12:51.370 --> 00:12:55.300
And this is what goes to the
owners of the company.

00:12:55.300 --> 00:12:57.910
This net income right here.

00:12:57.910 --> 00:13:01.000
So going back to our balance
sheet, we had a $10 million

00:13:01.000 --> 00:13:03.540
asset, we had $5 million
of debt.

00:13:03.540 --> 00:13:06.600
We know what's left over
is the equity.

00:13:06.600 --> 00:13:09.640
So let me do that in
a vibrant color.

00:13:09.640 --> 00:13:11.120
Equity is what's left over.

00:13:11.120 --> 00:13:14.100
So let's say this is
all book value.

00:13:14.100 --> 00:13:15.880
So we have $5 million
of equity.

00:13:15.880 --> 00:13:18.430
And when I say book value,
that's just a fancy way of

00:13:18.430 --> 00:13:21.810
saying this is what our
accountants say that we paid

00:13:21.810 --> 00:13:22.830
for the stuff.

00:13:22.830 --> 00:13:24.180
This is what we have
on our books.

00:13:24.180 --> 00:13:26.920
And we'll talk later about
depreciation and amortization

00:13:26.920 --> 00:13:30.620
and how we might change what
these values are, but a very

00:13:30.620 --> 00:13:33.380
simple way is, if you went out
and bought $10 million worth

00:13:33.380 --> 00:13:34.910
of stuff, you'd write on
your books, I have

00:13:34.910 --> 00:13:36.250
a $10 million asset.

00:13:36.250 --> 00:13:40.010
And if you took a $5 million
loan, then what you really

00:13:40.010 --> 00:13:42.260
own, if you were to kind of sell
all of this, you would

00:13:42.260 --> 00:13:46.955
get $5 million of equity.

00:13:46.955 --> 00:13:48.890
And I think this is an
interesting thing.

00:13:48.890 --> 00:13:51.630
When we did return on asset,
we looked at the operating

00:13:51.630 --> 00:13:55.010
profit, because this is what our
company generated before

00:13:55.010 --> 00:13:57.820
we paid the bank or Uncle Sam
or anything like that.

00:13:57.820 --> 00:14:01.340
And so we took this number as
the numerator and we divided

00:14:01.340 --> 00:14:02.840
by the number of assets.

00:14:02.840 --> 00:14:06.285
Now we can do another notion,
and that's return on equity.

00:14:06.285 --> 00:14:11.630


00:14:11.630 --> 00:14:14.620
In return on equity, the
numerator is the net income

00:14:14.620 --> 00:14:19.460
that we got, so it's $350,000.

00:14:19.460 --> 00:14:23.120
And the denominator here is the
equity, the book value of

00:14:23.120 --> 00:14:26.040
our equity, so that's
$5 million.

00:14:26.040 --> 00:14:27.300
One, two, three.

00:14:27.300 --> 00:14:28.200
One, two, three.

00:14:28.200 --> 00:14:30.250
Let's cancel some zeroes out.

00:14:30.250 --> 00:14:33.380
So it's like 35/500.

00:14:33.380 --> 00:14:38.230
35/500 is the same thing
is 7/100, so it equals

00:14:38.230 --> 00:14:42.460
7% return on equity.

00:14:42.460 --> 00:14:44.650
And that's interesting because,
well, why that's

00:14:44.650 --> 00:14:48.780
lower is-- well, I don't want
to go into too much depth

00:14:48.780 --> 00:14:51.330
because I realize I'm already
pushing my time limit.

00:14:51.330 --> 00:14:53.730
But at this point, you should
have a good understanding of

00:14:53.730 --> 00:14:57.720
at least a basic income
statement of a company that

00:14:57.720 --> 00:14:58.420
sells widgets.

00:14:58.420 --> 00:15:00.010
And in the future, we're gonna
look at a lot of different

00:15:00.010 --> 00:15:01.830
companies, financial companies,
insurance

00:15:01.830 --> 00:15:05.650
companies, natural gas pipeline
companies, that will

00:15:05.650 --> 00:15:08.100
have very different-looking
income statements, but this

00:15:08.100 --> 00:15:10.210
gives you the general template
for how things work.

00:15:10.210 --> 00:15:13.920
And at least it'll give you a
sense of how revenues, gross

00:15:13.920 --> 00:15:17.300
profit, operating profit,
pre-tax income and net income

00:15:17.300 --> 00:15:18.570
really are different.

00:15:18.570 --> 00:15:19.960
A lot of times in the
popular press.

00:15:19.960 --> 00:15:22.940
They're all jumbled up as just
kind of the company is making

00:15:22.940 --> 00:15:23.930
this much money.

00:15:23.930 --> 00:15:26.490
Anyway, I'll see you
in the next video.

00:15:26.490 --> 00:15:26.500