PBL 7 Profit and Income statements

Where does the profit come from?

More sales, less expenses

What is an income statement?

By looking at income statement, you have access to financial performance of a firm over a certain period of time. (Most of the time, this period is a quarter or a year for a public firm)

Income statement summarizes firm's revenues, expenses, gains, and losses over a period of time.

Components of income statement:

• Sales
• Cost of sales
• Operating expenses
• Other income
• Income taxes
• Extraodinary gain/losses

The income statement is divided into two parts: operating and non-operating. 

The operating portion of the income statement discloses information about revenues and expenses that are a direct result of regular business operations. For example, if a business creates sports equipment, it should make money through the sale and/or production of sports equipment. 

The non-operating section discloses revenue and expense information about activities that are not directly tied to a company's regular operations. Continuing with the same example, if the sports company sells real estate and investment securities, the gain from the sale is listed in the non-operating items section.

(Source: Income statement)

What is a balance sheet?

The balance sheet presents a company's financial position at the end of a specified date. Some describe the balance sheet as a "snapshot" of the company's financial position at a point (a moment or an instant) in time. For example, the amounts reported on a balance sheet dated December 31, 2015 reflect that instant when all the transactions through December 31 have been recorded.

Because the balance sheet informs the reader of a company's financial position as of one moment in time, it allows someone—like a creditor—to see what a company owns as well as what it owes to other parties as of the date indicated in the heading. This is valuable information to the banker who wants to determine whether or not a company qualifies for additional credit or loans. Others who would be interested in the balance sheet include current investors, potential investors, company management, suppliers, some customers, competitors, government agencies, and labor unions.

We will begin our explanation of the accounting balance sheet with its major components, elements, or major categories:

• Assets
• Liabilities
• Owner's (Stockholders') Equity

Assets: Resources a company owns to create value, and it has 3 features which are controlled by a firm, probable economic benefits, sufficient reliabilty to estimate these benefits e.g. cash inventories, production machines

• Current assets: assets with relatively short life, e.g. cash, inventories, accounts receivable (future payments from customers, usually collected within a year)
• Long-term assets: assets with relatively long life, e.g. building equipment

Liabilities: in other words, obiligations: Able to transfer economis benefits in the future, Measurable, Benefits which creates the obiligation received e.g. accounts payable, wage payable, debt

• Current liabilities: amounts due within a year (e.g., account payable, wage payable)
• Long-term liabilities: amounts due after one year (e.g., 15-year bank loan)
• Provisions: amounts where there is at least reasonable certainty that an obiligation will be incurred on some future data (e.g., settlement of environmental hazards)

Shareholder equity: Investment of share holders= the difference between total assets and total liabilities (shareholders' equity= assets-liabilities)

• Common
• Additional paid-in capital
• Retained earnings

(Source: Balance sheet, Balance sheet (Explanation), cousera: financial accounting)

How to analyze the financial statements? (Focus on income statement and balance sheet)

Income statement

• Revenue: The best way for a company to improve profitability is by increasing sales revenue. The best revenue are those that continue year in and year out. Temporary increases, such as those that might result from a short-term promotion, are less valuable and should garner a lower price-to-earnings multiple for a company. 

• What are the Expenses? 

• Profits = Revenue - Expenses 

Balance sheet

Assets: 

• Cash: Investors normally are attracted to companies with plenty of cash on their balance sheets. After all, cash offers protection against tough times, and it also gives companies more options for future growth. Growing cash reserves often signal strong company performance. Indeed, it shows that cash is accumulating so quickly that management doesn't have time to figure out how to make use of it. A dwindling cash pile could be a sign of trouble. That said, if loads of cash are more or less a permanent feature of the company's balance sheet, investors need to ask why the money is not being put to use. Cash could be there because management has run out of investment opportunities or is too short-sighted to know what to do with the money. 
  
• Receivables:are outstanding (uncollected bills). Analyzing the speed at which a company collects what it's owed can tell you a lot about its financial efficiency. If a company's collection period is growing longer, it could mean problems ahead. The company may be letting customers stretch their credit in order to recognize greater top-line sales and that can spell trouble later on, especially if customers face a cash crunch. Getting money right away is preferable to waiting for it - since some of what is owed may never get paid. The quicker a company gets its customers to make payments, the sooner it has cash to pay for salaries, merchandise, equipment, loans, and best of all, dividends and growth opportunities. 

• Non-current assets: This includes items that are fixed assets, such as property, plant and equipment (PP&E). Unless the company is in financial distress and is liquidating assets, investors need not pay too much attention to fixed assets.

Liabilities: You usually want to see a manageable amount of debt. When debt levels are falling, that's a good sign. Generally speaking, if a company has more assets than liabilities, then it is in decent condition.


Equity

Equity = Total Assets – Total Liabilities

The two important equity items are paid-in capital and retained earnings. Paid-in capital is the amount of money shareholders paid for their shares when the stock was first offered to the public. It basically represents how much money the firm received when it sold its shares. In other words, retained earnings are a tally of the money the company has chosen to reinvest in the business rather than pay to shareholders. Investors should look closely at how a company puts retained capital to use and how a company generates a return on it. 

(Source: Foundamental analysis: The income statement, Foundamental analysis: The balance sheet)