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What is the Income Statement, what does it tell us, and an overview of some of the line items in it.
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Quick reference
Income Statement
Understand the Income Statement.
When to use
It is necessary to understand the Income Statement when building a Financial Model
Instructions
Income Statement:
- Reports financial performance
- Prepared on an accruals basis
- Summarises a period of time
- Provides a summary of net OPERATING profit after tax
- Historically used for valuation purposes
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- 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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