Corporate Finance For Dummies. Michael Taillard
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while the income statement includes only depreciation incurred that year. But the amount of depreciation incurred in the year will go into the balance sheet’s cumulative total.
To get the operating income, you just add up all the costs listed in the preceding three sections and then subtract that number from the gross margin. Because the operating income represents the amount of money a company has left over after it has paid for all its standard operations, companies need to consider it when planning whether to expand, whether to use equity or debt to fund expansion, and how much money they can borrow and safely pay back using their primary operations. Operating income is also useful in other metrics, such as liquidity, which I cover in Chapter 7.
Earnings before interest and taxes (EBIT)
Over the course of doing business, a company incurs costs or generates income from a number of activities that aren’t related to the company’s normal operations. The goal in this portion of the income statement is to account for all these other costs and revenues so the company can make smart financial decisions on debt and so it knows how much to pay in taxes. The final calculation in this portion is called earnings before interest and taxes (EBIT), and it includes the following elements:
Other income: This includes anything the company does other than its main business that generates income. For example, a company that has an extra office in its building that it isn’t using can rent that office out to others, thereby generating other income. Similarly, a company can sell off a piece of old equipment to buy new equipment. The money it makes by selling the old equipment falls into the other income category.
Other expenses: This includes anything the company does other than its main business that incurs costs. As with other income, other expenses can vary widely. If a company spends or loses money that doesn’t belong in any other category, it counts here. Taxes are one of the most common other expenses a company incurs. Companies can include any taxes they must pay, other than income taxes, in this portion. Income taxes go in the net income portion of the income statement (see the next section).
Profit/loss for discontinued operations: Any time a company decides to stop pursuing one or more of its operations, the amount of profit or loss experienced from stopping, as well as the amount generated from running those operations up until that point, goes here. In other words, if a company is losing money on some operation and it decides to stop that operation halfway through the period, the amount of money the company lost up until that period is included here. In addition, any money the company received from selling the equipment for that operation or paying off lawsuits for the operation is included here.
You calculate EBIT by taking gross margin and then subtracting or adding the different sources of costs and revenues associated with nonprimary business operations. Essentially, earnings before interest and taxes is the total amount the company made before lenders and the government get their hands on the company’s profits. It’s an important value for companies and investors to consider because this income statement item shows how much money the company is making and how much it has to pay in taxes. For example, a company that’s making less money this year than last year will pay less taxes. So, all in all, the earnings before interest and taxes determine whether a company can make money the way it’s currently operating.
Net income
The final portion of the income statement that lists costs and revenues is called net income and deals exclusively with taxes and interest. A company has to pay the taxes and interest charges that appear in this section, but the amounts due are often related to the amount of money the company makes. As a result, the company has to account for all other expenses and revenues before it can calculate these final items and determine the company’s total profits. Here’s a breakdown of what goes into net income:
Interest income: A company can earn interest when it has some types of bank accounts, when it owns bonds or other forms of debt on individuals or companies, or when it purchases money-market investments like certificates of deposit. All this interest falls under interest income on the income statement.
Interest expense: A company can generate interest expense when it borrows money from a bank or other organization or when it issues bonds. All the interest that a company pays, regardless of where the interest expense comes from, goes into the interest expense portion of the income statement.
Income tax expense: Like people, companies must pay taxes on the income they generate. The amount of income taxes a company pays is based on their EBT (earnings before tax, but not interest). So if a company makes $100 in a tax year and it has to pay 6 percent in income tax, then it has to pay $6. Many companies also list the percentage of income taxes in this section, but it isn’t required.
Net income is calculated by taking EBIT and subtracting all interest and tax expense. Simply put, the net income is the final amount that a company walks away with after it has considered all costs. It includes all revenues and all costs and represents the final profits that a company was able to generate during the period. The company must either distribute the money from net income to its stockholders (who own the company) or reinvest it into the company for improvements and expansion. Either way, the money from net income belongs to the company owners and must contribute to the value of their ownership in the company.
Earnings per share
In the portion of the income statement immediately following net income, corporations have to include the amount of earnings each share of stock they have outstanding has generated. Here are the two main components of this portion, aptly called earnings per share (EPS):
Basic earnings per share: Companies calculate the basic earnings per share by dividing net earnings by the total number of common shares outstanding. This calculation tells investors how much money each share of stock they own earned during the period. For example, if a company made $1,000 during a year and has a total of 1,000 shares of stock, then everyone who owns that company’s stock made $1 per share of stock.
Diluted earnings per share: Companies can issue a number of options that can eventually turn into common stock. For example, company employees may be given stock options, or preferred shares and convertible bonds may be converted into common stock. The diluted earnings per share does the same thing as basic earnings per share except that it assumes all these different holding options have been turned into common shares. So a company that made $1,000 and has 1,000 shares of stock has an earnings per share of $1. But if that company also has 1,000 shares of convertible preferred stock, its diluted earnings per share is $0.50.
Supplemental notes
Sometimes events that alter a company’s income occur but don’t have a place on the income statement or require additional comments. Anything of this sort goes in the supplemental notes portion of the income statement. Examples include the following:
A switch from LIFO inventory cost accounting to FIFO inventory cost accounting
An unusual or infrequent event, such as finding an oil reserve where your new building is being constructed and selling it for extra revenues
Any discontinued operations or unusual earnings from subsidiaries
Putting the Income Statement to Good Use
By itself, the information you find in the income statement is great for tracking expenses and revenues, corporate revenue management, and dividend policy. But you can find out even more by comparing the same company’s income statements over a series of years. In fact, by watching for trends in a company’s income statements, you can identify successes or problems with specific operations that generate costs relative to the amount that the operations contribute to generating revenues. And, of