Income Statement

Quick reference

• 00:05 The first of our three financial statement types then is the income statement.
• 00:11 Again, it's a summary of revenues, costs of goods sold,
• 00:16 and expenses for a period of time calculating the net profit after the tax.
• 00:23 This is typically what a P&L, or an income statement, looks like.
• 00:27 You start off with revenue of x, you deduct off your cost to goods sold x, and
• 00:31 that gives you your gross profit, also x.
• 00:34 So if you solve for x, x must be 0, and
• 00:36 therefore this must be a not-for-profit organization, I suppose.
• 00:40 Lots more x's ensue, as we deduct off operating expenditure.
• 00:45 That used to be called net profit, but
• 00:47 it's now earnings before interest tax depreciation and amortization.
• 00:52 As depreciation and amortization are then deducted off to give us earnings before
• 00:56 interest and tax, or EBIT.
• 00:58 Deduct interest expense from net profit before tax, and
• 01:02 then knock off tax expense to give us NPAT, net profit after tax.
• 01:06 It's our operating profits for a period of time.
• 01:09 Now one of the things I always find interesting about this is I've never been
• 01:13 great at learning things by rote.
• 01:15 I've always needed to understand the whys and wherefores.
• 01:18 And most of us actually think in P&L terms.
• 01:21 We may not be accountants but this is how we think.
• 01:24 If you take a good hard look at yourself and think how might I build a model,
• 01:28 you may actually realize you would have built it in
• 01:31 the order displayed with the P&L here.
• 01:34 And that's because this is how we think.
• 01:36 Say if we sell a million widgets at $1 each, we'd get $1 million at the end.
• 01:41 And that's right for revenue purposes, but
• 01:43 may not actually reflect the cash flow position.
• 01:47 Now, why the order?
• 01:49 Well, obviously revenue's at the beginning and net profit after tax at the end.
• 01:53 What about the rest?
• 01:54 Well, I think it makes sense that tax expense is at the bottom,
• 01:57 because tax is paid on everything, so that's fair enough.
• 02:01 And it may be fair enough also about cost of goods sold being next,
• 02:05 because this is what we call a direct cost.
• 02:08 A lot of people think the difference between cost of goods sold and
• 02:11 operating expenditure is cost of goods sold is variable and
• 02:15 operating expenditure tends to be fixed.
• 02:17 This isn't true.
• 02:18 I've lectured a lot of accountants over the years, and
• 02:21 a lot of people have given me this answer, and it's not right.
• 02:25 Typically, cost of goods sold is variable and
• 02:27 typically operating expenditure is fixed.
• 02:30 But that's not what makes COGS COGS, and OPEX OPEX.
• 02:35 No, what makes cost of goods sold cost of goods sold
• 02:38 is the fact that the cost is directly attributable to the revenue.
• 02:42 That is, if you don't incur the sale, you won't actually incur the cost.
• 02:47 So it might be the direct materials, if I'm not going to make the widget,
• 02:52 I won't buy the raw materials for it.
• 02:54 If it requires casual staff and wrapping I won't actually have the casual staff or
• 02:58 the wrapping materials if I don't make the sale.
• 03:01 That's cost of goods sold.
• 03:02 Whereas, operating expenditure are expenses you will
• 03:05 incur in the medium-term anyway, regardless of whether you make a sale.
• 03:10 You're going to have to pay your overheads, such as people's pay.
• 03:15 You're going to have to pay for a building, a warehouse, things like that.
• 03:19 So it makes sense that cost of goods sold goes before operating expenditure.
• 03:24 But why did depreciation and interest expense go that way round?
• 03:27 You may recall depreciation expense is actually the allocating of a large
• 03:33 capital expenditure over a significant number of periods, more than one year.
• 03:38 Because of the fact that this asset isn't for resale.
• 03:41 It's for continuing use in the business to actually make things better,
• 03:45 give us more profit.
• 03:46 It might be a widget making machine, it might be a warehouse,
• 03:48 it might be a fleet of cars for the sales team, whatever.
• 03:51 It would be wrong to put it all in one year because the P&L would go down
• 03:55 massively.
• 03:55 You might make a big loss in that year and for the next few years make a profit,
• 03:59 and no one would actually understand the nature of the business.
• 04:01 So we smooth it out by allocating so much expense each year.
• 04:04 And there's different ways of doing that, and we'll talk about that later.
• 04:08 Interest expense though is a function of debt.
• 04:10 Now, why is it that way round?
• 04:12 Well, if you're buying another company,
• 04:15 you're still gonna have the capital assets in there, aren't you?
• 04:17 So the depreciation will still be incurred.
• 04:20 But if you buy it, you might not have any debt, so
• 04:22 the interest may not be relevant to you.
• 04:25 And that's why interest comes after depreciation.
• 04:29 And when it's explained to me like that, I say I see.
• 04:32 And the relevance for
• 04:33 this, this helps you to understand why you should model in the order you do.
• 04:38 You can't model COGS until you know what your revenue sales are.
• 04:41 Your OPEX, you don't know what your infrastructure's going to be until you
• 04:44 know your likely sales plan.
• 04:45 Your depreciation requires capital assets that you've no idea what level of
• 04:49 infrastructure you're going to need until you have your business plan sorted out.
• 04:53 And the interest expense is, how much money have I got to actually be able to
• 04:56 afford this, and how much do I need to borrow?
• 04:58 We're gonna have to pay tax on it.
• 04:59 And you start to say, this makes sense.
• 05:02 I'm following a plan here.
• 05:03 If I build in this order, I'm gonna have a model that pretty much follows my P&L.
• 05:08 So this whole idea here is it will report the financial performance.
• 05:12 It does it on an accruals basis, it's not about the cash.
• 05:15 It's about looking at the costs and
• 05:17 revenues that are actually associated with a particular period.
• 05:21 Like the depreciation example I gave you.
• 05:23 It provides a summary of net operating profit and historically, it was used for
• 05:27 valuation purposes.
• 05:28 People would often take multiples of one of the line items in here.
• 05:32 So that if you had two companies, one had double the net profit after tax of another
• 05:36 and they worked in the same industry,
• 05:38 you would say well, that should be worth twice as much, shouldn't it?
• 05:41 And that was difficult to refute.
• 05:43 That's the P&L.
• 05:44 There's still two other financial statements, and
• 05:47 next up is the balance sheet.

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