Introduction to the Income Statement

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.

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.