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Current time:0:00Total duration:15:27

Video transcript

I figured now is a good time as any to learn about probably what 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 look at when you look at a company there's the income statement the other two are the balance sheet which I have drawn a lot and 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 no it's not of course you don't know it is the cash flow statement cash flow statement cash flow statement it will 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 would be you know four 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 you see but sometimes even there's you know there's monthly or six-month income statements and and the general format is it's pretty consistent although you know there's 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 know you you make it and you just sell it right you sell the widget you give a customer a widget and and they give you some money right and that money that they give you and I'm not going to get too technical about the accounting right now is considered revenue revenue it's sometimes considered sales and that's literally the money that they give you in a certain period of time and some of you accountants out there is 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 for our sake let's just say that 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 income statement for 2008 so over 2008 we sold I don't know say three million dollar worth of widgets let me say and let me do same color so let's say it's three million dollars 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 three million they'll you'll see three thousand there's like oh my god this company they they're hardly selling anything but it's kind of a standard is that they tend to write things in thousands so three thousand would be three thousand thousands which would be three million and for really big companies actually sometimes write their numbers in millions so if you saw three thousand there it would actually mean three billion but it will actually look at real income statement to the not too far our future so that's how much money they give us but that's not that's not how much income we made because there was a lot of costs that went into making that widget that we have to account for it's not like when someone gives me three million dollars I can just say oh I made three million dollars let me just put it all on the bank I'm done that was all 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 those it'll-it'll some and I'll put all my expenses in let's do it in magenta so it'll sometimes be written as cost of sales cost of or cost of goods sold 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 the cost of goods is literally how much did it cost to buy the metal and the paint and and provide the electricity to make those those three million dollars worth of widgets and then on that's a variable cost and then on top of that you have the fixed cost where maybe or the relatively fixed cost where you know just to run the 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 of those costs of making the widgets were $1,000,000 so sometimes someone might say it's a $1,000,000 cost I like to when I make models I'd like to put a minus there so that I remember that that's a cost anything that it detracts from income I put as a - anything that adds as a plus although that's not necessarily the standard convention some people say oh it's a positive one million dollar cost which means you subtract but either way I think you get the point and then if you 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 gross profit gross profit in this case it would be two million dollars two million dollars and this number tells you how much money did you make did you or how much profit did you make just from selling these widgets so - you know the more widgets you sell in most circumstances the larger this number is going to be so this is this is your profit before all of the other expenses that a company has to incur like the taxes and the CEO salary right the CEO salary doesn't go in here right because the cost of making a widget doesn't the CEO doesn't go out there into the factory in most cases and actually help make the widget so the CEO salary or the CFO salary or the the headquarters on 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 it's you know they'll have marketing expense marketing sometimes they'll have as sometimes you have to pay salespeople so you might have sales expense sales and then the stuff like the corporate office and the CEO salary and you have to hire auditors and accountants and all that that might be included is is 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 see SGA G&A just stands for general and administrative expenses if you see SGA sometimes instead of that you see SG na that means selling general and administrative expenses selling is things like it could be the Commission's that the salespeople get it could be just the cost of having salespeople travel around the country and taking people out to steak dinners you know and then the general and administrative that's just all the stuff that the corporate office does and all of the people who are at that level so if you subtract these and I'm just making up these numbers as I go say marketing the company is spending its my $500,000 and I'm putting it as a - because I like to remember it's an expense some models you'll see they'll just write it so if it's 500,000 expense sales let's say let's say let's say this is just GNA here I don't want I want to make a separate line for sale so let's say sales selling expenses is $200,000 and let's say GNA the corporate office is and all of that let's say that's another $300,000 $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 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 an operating profit and net profit and pre-tax profit and it's very hard to understand that these are actually very very different things because they all have the word in profit and you know what is gross and operating and all of that mean but here you see it means very very different things and let's calculate this number first before I go off on on one of my tangents on all the differences between the operating and the gross profit let's see two million - and see a million my head I think implicitly made the numbers work out nicely so my operating profit here is 1 million dollars so already we have some nuance on top profit I made 2 million dollars 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 a million dollars 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 is generating but we can see you know I've drawn a bunch of balance sheets before and I think this is a good time to draw a balance sheet let me so you have kind of the assets of a company and we'll talk a little bit more about assets and enterprise value or 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 its funded if you just think about the enterprise itself the assets the assets are generating this right they're generating the off operating profit and that's a very important thing to realize future in the future when we talk about return on asset actually could talk about it now if let's say our assets if we paid if we paid let's say ten million dollars for these assets and these assets this is the income statement for 2008 are spitting out a million dollars a year at least a million dollars in this year our return on asset I wasn't planning on introducing this but doesn't hurt to introduce it right now our return on asset often talked often acronym ROA a return on asset would be well the numerator is the return which is 1 million dollars 1 million the denominator is the assets 10 million so we got 10% return on our assets right for 10 million dollar investment we're getting a million dollars a year we're getting 10% of our 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 it's very closely tied to operating profit and and the actual assets of a firm what we've learned and especially if you watch 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 is a 10 had 10 million dollars of assets but let's say they paid for it with 5 million dollars of debt 5 million dollars of debt and let's say the interest rate on that debt is anim think of a good number let's say the interest rate on that debt is 5 percent so let me make it yeah well let's make it 5 percent 5 I don't make it easier I want to make it 10 percent interest right so this is their 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 interest expense and obviously a company that has no debt will have no interest expense but this case we do and this is an annual income statement so as you have five million dollars of debt and it's and we're paying ten percent on that ten percent of five million dollars it's five hundred thousand dollars 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 we're getting close to where we need to get to we're left with our pre-tax income pre-tax income and if we do the subtraction we're at $500,000 $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 right so you could guess what the next line is it's going to be taxes taxes let's say that it's a 30% corporate tax rate so 30% and you're going to pay take 30% of this number right here 30% of that number right there so 30% of 500,000 is $150,000 $150,000 and then we are done we finally have paid off everybody we need to pay off so we started off with three million dollars up here we kept paying a bunch a bunch of expenses and then now we're left with what this is three hundred and fifty thousand dollars three hundred and fifty thousand dollars of net income 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 the ten million dollar asset we had five million dollars of debt we know what's left over is the equity so let me do that in a in a vibrant color equity is what's left over so the let's say dissolve book values so we have five million dollars 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 this how we might change what these values are but a very simple way is if you went out and bought ten million dollars worth of stuff you'd write on your books I have a ten million dollar asset and if you took a five million dollar loan then what you really owned if you were to kind of sell all of this you would get five million dollars of equity of equity now this is an interesting thing 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 we took this number as a numerator and we divided by the number of assets now we can do another notion and that's return on equity return on equity so return on equity and return on equity the numerator is the net income that we got so it's three hundred and fifty thousand dollars and the denominator here is the equity the book value of our equity so that's five million dollars one two three one two three let's cancel some zeroes out so it's like thirty five over five hundred thirty five over five hundred is the same thing as seven over 100 so it equals seven percent return on equity and that's interesting because well why that's lower is even well I don't wanna go to and to tap into too much depth just because I realize I'm already pushing my time limits but at this point you should have a good understanding of at least a basic income statement of what kind of a company that sells widgets and in the future we're gonna look at a lot of different companies financial companies insurance companies of 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 will give you a sense of what how revenues gross profit operating profit pre-tax income and net income really are different and it's a lot of times in the popular press they're all jumbled up is just kind of but he's making this much money anyway I'll see you the next video