I figure now is as good a time as any to learn about probably
what most people focus the most on when they analyze
companies, and that's the income statement.
And the income statement is one of the three financial
statements that you'll look at when you look at a company.
There's the income statement and the other two are the
balance sheet, which I have drawn a lot in a lot of the
other explanations I've done on the financial crisis and
whatever else.
And actually, in this video, we're going to see how the
income statement relates to the balance sheet.
And, of course, the last one-- well, it's not of course if
you don't know it-- is the cash flow statement.
And we'll focus on that a little bit later because
that's a little bit more nuanced relative
to the income statement.
So the income statement is literally just saying how much
a company might earn in a given period, and it's always
related to a period.
So it could be an annual income statement.
It could be for the year 2008.
It could be a quarterly income statement.
Those are usually the two types that you see, but
sometimes, there's monthly or six-month income statements.
And the general format is pretty consistent, although
there is a lot of variation depending on what a business
does, but in this video, I really just want to cover
almost a plain vanilla income statement for a company that
just sells a widget.
So the first thing when you sell a widget is you make it
and you just sell it.
You sell the widget.
You give a customer a widget, and they give you some money.
And that money that they give you-- and I'm not going to get
too technical about the accounting right now-- is
considered revenue.
It's sometimes considered sales.
And that's literally the money that they give you at a
certain period of time.
And some of you accountants out there are like, oh, well,
no, that's not just the money that they give you.
It's the money that you've earned in a certain period of
time, and that's true.
But for our sake, let's just say that when you give the
widget, you have earned the money that they give you, and
that's revenue sales.
Later on, we'll talk about different ways to account
revenue and sales.
So let's say the revenue or the sales in this case in a
given period, let's say that this is an income
statement for 2008.
So over 2008, we sold let's say $3
million worth of widgets.
So let's say it's $3 million.
And a lot of times when you look at income statements for
companies, if you go to Yahoo!
Finance, you could do this right now, instead of writing
$3 million, you'll see $3,000 there.
It's like, oh, my God!
This company, they're hardly selling anything.
But it's kind of a standard that they tend to write things
in thousands.
So 3,000 would be 3,000 thousands,
which would be 3 million.
And for really big companies, they actually sometimes write
their numbers in millions.
So if you saw 3,000 there, it would actually mean 3 billion.
But we'll actually look at real income statements in the
not-too-far-off future.
So that's how much money they give us.
But that's not how much income we made, because there was a
lot of cost that went into making that widget that we
have to account for.
It's not like when someone gives me $3 million, I can
just say, oh, I made $3 million.
Let me just put it all in the bank.
I'm done.
That was all income.
So the first thing that you tend to see on an income
statement is the cost of those actual widgets, the cost of
producing those widgets.
And I'll put all my expenses in magenta.
So it'll sometimes be written as cost of sales or cost of
goods sold.
And this is literally-- well, there's two things.
There's a variable cost which is, each widget, they might
have used some amount of metal and some amount of energy to
produce it and some amount of paint if
it's a painted widget.
And so that the cost of goods is literally how much did it
cost to buy the metal and the paint and provide the
electricity to make those $3 million worth of widgets.
That's the variable cost. And then on top of that you have
the fixed costs, or the relatively fixed costs, where
just to have the factory open, it costs a certain amount of
money every year, regardless of how many widgets you make.
And we'll go into more detail on that, But for simplicity,
let's say all those costs of making the
widgets were $1 million.
So sometimes someone might say it's a $1 million cost. When I
make models, I like to put a minus there, so that I
remember that that's a cost. Anything that detracts from
income I put as a minus.
Anything that adds is a plus, although that's not
necessarily the standard convention.
Some people say, oh, it's a positive $1 million cost,
which means you subtract.
But either way I think you get the point.
And then if you subtract your costs from your revenue, or if
you just add these two numbers, because this one is
negative, you have your gross profit.
And in this case, it would be $2 million.
And this number tells you, how much money did you make, or
how much profit did you make just from
selling these widgets?
So the more widgets you sell, in most circumstances, the
larger this number is going to be.
So this is your profit before all of the other expenses that
a company has to incur, like the taxes
and the CEO's salary.
The CEO's salary doesn't go in here, right?
Because the CEO doesn't go out there to the factory in most
cases and actually help make the widget.
So the CEO's salary or the CFO's salary or the
headquarters in a nice skyscraper, that doesn't get
factored in here.
Or the marketing expense, right?
You have to tell people, hey, we make good widgets.
So none of that is factored in here.
So that goes into the next line.
And oftentimes, you'll see it broken up, where they'll have
marketing expense.
Sometimes you have to pay salespeople, so you might have
sales expense, and then the stuff like the corporate
office and the CEO's salary, and you have to hire auditors
and accountants and all of that.
That might be included as general.
Actually, I should be doing this in magenta because it's
all expenses.
Marketing, sales, and then G&A you'll sometimes see.
Sometimes you'll see SG&A.
G&A just stands for general and administrative expenses.
If you see SG&A-- sometimes instead of that you'll see
SG&A-- that mean selling, general and
administrative expenses.
Selling is things like, it could be the commissions that
the salespeople get.
It could be just the cost of having salespeople travel
around the country and taking people out to steak dinners.
And then the general and administrative, that's just
all the stuff that the corporate office does, and all
the people who are at that level.
So if you subtract these, and I'm just making up these
numbers as I go.
Say, in marketing, the company is spending $500,000.
And I'm putting it as a minus because I like to remember
it's an expense.
Some models you'll see, they'll say
it's $500,000 expense.
Sales, let's say, this is just G&A here.
I want to make a separate line for sales.
So let's say sales, selling expenses is $200,000.
And let's say G&A, the corporate offices and all of
that, let's see that's another $300,000.
And now we're ready to figure out how much money did the
operations of this business make?
So this is operating profit.
This is really important to pay attention to, because so
many people say, oh, a company made this much.
And you'll hear these numbers, gross and operating profit and
net profit and pretax profit, and it's very hard to
understand that these are actually very, very different
things, because they all have the word "profit," and what
does gross and operating and all that mean?
But here you see it means very, very different things.
Let's calculate this number first before I go off on one
of my tangents on all the differences between the
operating and the gross profit.
But let's see, 2 million minus 1 million.
My head I think implicitly made the
numbers work out nicely.
So my operating profit here is $1 million.
So already we have some new nuance on profit.
I made $2 million just from actual widget sales, but then
when you take out all of the overhead of the company, the
marketing, the sales, the general and administrative
expenses, I'm only left with $1 million.
And this is the profit from the operations of the company,
or you could say from the assets or from the business or
from the enterprise of the company.
That's what it is generating.
But we can see-- I've drawn a bunch of balance sheets before
and I think this is a good time to draw a balance sheet.
So you have kind of the assets of a company.
And we'll talk a little bit more about assets and
enterprise value, and there's a little bit of a nuance
there, but essentially the company itself.
Before you think about how the company is paid for or how
it's funded, if you just think about the enterprise itself,
the assets.
The assets are generating this.
They're generating the operating profit, and that's a
very important thing to realize in the future when we
talk about return on assets.
Actually, we could talk about it now.
Let's say our assets, if we paid $10 million for these
assets, and these assets-- this is the income statement
for 2008-- are spitting out $1 million a year, or at least $1
million in this year, our return on asset-- I wasn't
planning on introducing this, but it doesn't hurt to
introduce it right now-- our return on asset, often
acronymed ROA, would be-- well, the numerator is the
return, which is $1 million.
The denominator is the assets, $10 million.
So we got a 10% return on our assets.
For a $10 million investment, we're getting
$1 million a year.
We're getting 10% of our asset investment back every year.
So that's a nice thing to keep in the back of your mind, this
return on asset concept, and it's very closely tied to
operating profits and the actual assets of a firm.
What we've learned, and especially if you watched some
of my other economics videos, that all companies aren't
financed the same.
A lot of them might have some debt.
So let's say that company had $10 million of assets, but
let's say they paid for it with $5 million of debt.
And let's say the interest rate on that debt is-- let me
think of a good number-- 5%.
Let's make it easier.
Let's make it 10% interest.
So this is the operating profit.
This is the money that just comes out of the asset itself.
But, of course, that's not the money that we get to take
home, because we have to pay this interest. So let's throw
that in there as an expense.
Interest expense.
And obviously, a company that has no debt will have no
interest expense, but in this case, we do.
And this is an annual income statement.
So let's see, if we have $5 million of debt, and we're
paying 10% on that, 10% of $5 million is $500,000 a year in
interest. So we have to essentially take half of our
operating profit and give it back to the bank.
And now we are left with our-- we're getting close to where
we need to get to-- pre-tax income.
And if we do the subtraction, we're at $500,000.
And you could guess what the next line is going to be,
given that this says pre-tax.
This is what the owners of the company get before they pay
the government.
So you can guess what the next line is.
It's going to be taxes.
Let's say that it's a 30% corporate tax rate, and you're
going to take 30% of this number right here.
30% of that number right there.
So 30% of $500,000 is $150,000.
And then we are done.
We finally have paid off everybody we need to pay off.
So we started off with $3 million up here.
We kept paying a bunch of expenses, and then now we're
left with what?
This is $350,000 of net income.
And this is what goes to the owners of the company.
This net income right here.
So going back to our balance sheet, we had a $10 million
asset, we had $5 million of debt.
We know what's left over is the equity.
So let me do that in a vibrant color.
Equity is what's left over.
So let's say this is all book value.
So we have $5 million of equity.
And when I say book value, that's just a fancy way of
saying this is what our accountants say that we paid
for the stuff.
This is what we have on our books.
And we'll talk later about depreciation and amortization
and how we might change what these values are, but a very
simple way is, if you went out and bought $10 million worth
of stuff, you'd write on your books, I have
a $10 million asset.
And if you took a $5 million loan, then what you really
own, if you were to kind of sell all of this, you would
get $5 million of equity.
And I think this is an interesting thing.
When we did return on asset, we looked at the operating
profit, because this is what our company generated before
we paid the bank or Uncle Sam or anything like that.
And so we took this number as the numerator and we divided
by the number of assets.
Now we can do another notion, and that's return on equity.
In return on equity, the numerator is the net income
that we got, so it's $350,000.
And the denominator here is the equity, the book value of
our equity, so that's $5 million.
One, two, three.
Let's cancel some zeroes out.
So it's like 35/500.
35/500 is the same thing is 7/100, so it equals
7% return on equity.
And that's interesting because, well, why that's
lower is-- well, I don't want to go into too much depth
because I realize I'm already pushing my time limit.
But at this point, you should have a good understanding of
at least a basic income statement of a company that
sells widgets.
And in the future, we're gonna look at a lot of different
companies, financial companies, insurance
companies, natural gas pipeline companies, that will
have very different-looking income statements, but this
gives you the general template for how things work.
And at least it'll give you a sense of how revenues, gross
profit, operating profit, pre-tax income and net income
really are different.
A lot of times in the popular press.
They're all jumbled up as just kind of the company is making
this much money.
Anyway, I'll see you in the next video.