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.