Table of Contents:

Income statement Basic Format: What to look for when analyzing an Income Statement Using the Income statement to determine the Breakeven point

 

 

Income statement

 

The income statement is one of the major 3 financial statements release by the typical firm (including the balance sheet and the cash flow statement)

 

The purpose of the income statement is to show the financial performance (profitability) of the firm over time.  While it is typically easy to see the final result (did we make a profit), the income statement aims to dig a little deeper in order to tell you what were the causes of earnings

 

- note: you don't need the income statement to show the earnings for a period. You could easily get that information right from a balance sheet by looking at the difference in retained earnings and making notes of the dividends paid. So, there has to be more of a reason to invest time in producing income statements...and that is to help investors know the reasons behind the earnings

 

 

 

Basic Format:

 

Revenues - Expenses = Income

 

 

What to look for when analyzing an Income Statement

 

Look for the EBIT (earnings before interest and taxes) to see earnings from operations before interest expenses and other charges.  This is particularly important to see how well the firm is behaving in operations.  This is much more important than earnings per share (EPS) which is calculated after deducting accounting charges for interest.

 

Be careful when looking at accounting statements because they may be significantly different than cash flow realities!

 

1.  GAAP - generally accepted accounting principles - give accounts quite a bit of freedom in how and what they include in the income statement.   Accountant might "smooth income" in order to meet analysts expectations!.  Depreciation charges can be manipulated depending upon which rate the company chooses.   Also, depending upon LIFO or FIFO inventory management systems, the income statement may be either inflated or deflated depending upon the accountants choice of inventory accounting.  There are also many other areas in which GAAP gives large leeway to accountants to make judgments that can affect the quality of the earnings.  Be careful, and don't confuse accounting income with real cash flows!

 

2.  non cash items - when looking at an income statement, be aware that some of the expenses are not actual cash flows.  This is particularly important with depreciation and deferred taxes which are deductions on the income statement, but are not real negative cash flows. 

 

3.  No mention of fixed vs. variable costs -  this is a real weakness of most income statements in that they do not distinguish between variable costs and fixed costs.  Instead, the typical income statement lumps costs into period costs which are expensed immediately, and product costs which are capitalized and then expensed over time through depreciation. 

 

 

 

Using the Income statement to determine the Breakeven point

 

see our discussion on breakeven analysis:

 

The problem is that most income statements do not separate out the variable costs from the fixed costs....but you need to know that in order to determine your breakeven point.  To do this, you need to transform the "standard" (absorption costing) income statement into a VARIABLE income statement.   (see discussion below)....

 

 

Standard (Absorption costing) Income statement

 

 

 

 

Since all companies are required to report using "Absorption" costing, they normally also report using the standard Gross profit income statement. It is useful, however, to be able to convert the ABS income statement to a Variable Income statement. This will help the analyst to be able to see operating leverage, and contribution margin.

 

 

 

Variable Income statement 

 

 

 

 

 

This is different than the standard Gross Margin income statement that companies normally use when reporting (based on absorption costing). The Gross Profit income statement is different in that it combines all inventoriable costs into the COGS figure at the top (FFO is included in the COGS when the firm sells the products), and it also shows all S&A expenses as period costs at teh bottom of the Income statement, as shown here:

 

 

Using the Variable Income statement to determine the break-even point, and the operating leverage

 

 

Breakeven analysis

 

When looking at a proposed project, it is useful to conduct a breakeven analysis to see how many units must be sold to cover your fixed costs.  This "job order costing" is done to figure out the amount of risk there is in the project.

 

The first thing you need to do is to make a Variable income statement, and figure out what is the contribution margin (revenues - variable costs).  You then subtract all of your fixed costs to come up with your operating income.  Subtract taxes to get your net income.  The goal is to make sure that you have enough contribution margin from this one project to cover your fixed costs of taking on this project (but please just consider only the relevant fixed costs for this project, and do not include non-relevant cash flows). 

 

The "indifference point" is where the project breaks even, ie where contribution margin just barely covers the fixed costs.

 

The risk of the project is determined by the operating leverage (contribution margin / net income).  the higher the operating leverage, the more risk of the project (or firm).  This is because if you take on additional debt (fixed interest costs), then the gap between C.M and N.I will be higher, which will result in a higher operating leverage ratio.  (net income will decrease with additional fixed expenses, but C.M stays high, so the ratio of CM / NI will be larger with added fixed costs).

 

This ratio is extremely useful when comparing two projects (or two companies).  The one with the higher operating leverage will show much higher returns at higher volumes of sales, but will suffer much larger losses at lower volume of sales.  We call it "leverage" because of the amplification effect.

 

 

 

 

 

 

Converting Absorption Income Statement to Variable I/S