The Income Statement

The income statement (also called the earnings report or profit-and-loss statement) reflects the results of operation over a period of time, in contrast to the balance sheet’s snapshot view of the company’s financial condition at a given instant. Again, every business must prepare an annual income statement for tax, legal and other purposes; nevertheless, semiannual, quarterly or even monthly statements can be extremely useful. The items included in the simplified income statement on page 6 will often be needed to create the financial ratios used in your analysis and covered in the next section. Briefly, here is a description of the items contained in a company’s income statement:

Sample Income Statement
Gross sales or revenues $ 605,000
Returns, discounts and allowances 30,000
Net sales or revenues 575,000
Cost of sales or goods sold 470,000
Gross margin or operating profit $ 105,000
Selling and administrative costs 60,000
Depreciation 5,000
Net operating profit $ 40,000
Interest income or nonoperating income 10,000
Interest expense or nonoperating expense 3,000
Net profit before taxes $ 47,000
Provision for federal income taxes 10,000
Net profit after taxes $ 37,000

Gross sales or revenues: The actual total dollars billed for goods sold or services provided, before returns, discounts and allowances granted. Sales income and accounts receivable determine this first line item.
Net sales or revenues: Gross sales minus returns, discounts and allowances.
Cost of goods sold: The amounts paid for the purchased materials, components and finished products; direct payroll, operating overhead; and other costs of acquiring or producing the prod¬ucts or services and making them available for sale. This line item often appears as less cost of goods sold.

Gross profit: The difference between net sales or revenues and the cost of the products or services sold. This represents the amount of money left to sell the product and perform the day-to-day operations of the business.
Selling and administrative costs: Selling costs include salespersons’ salaries and commissions, travel and entertainment expenses, sales promotion and advertising costs. Administrative costs include office salaries and expenses, executive salaries and other current support expenses that can’t be allocated to production or sales departments.

Depreciation: The costs of plant assets (or fixed assets: property, plant and equipment) are written off as expenses over their anticipated useful life. Not all fixed assets are depreciated, however. For instance, the value of land tends to appreciate in value because it does not typically wear out. There are various depreciation techniques an accountant can use. The simplest and most commonly used method in U.S. businesses is called the straight-line method of depreciation, which allows you to depreciate the same amount of expense each year of the estimated useful life of the asset. For example, an asset with a value of $10,000 and a useful life of 10 years will have an annual $1,000 depreciation expense each year.

Net operating profit: Gross profit, less selling costs and administrative overhead. This line item represents the profit generated by the normal operations of the business.
Nonoperating income: Interest and dividends received on investments, gains on the disposi¬tion of capital assets, etc.
Nonoperating expenses: Interest paid on long-term debts, losses on sales of capital assets, etc.


Net profit before taxes: Net operating profit, plus any nonoperating income and minus any nonoperating expenses.
Provision for federal income taxes: The estimated amount to be paid on operating earnings for the period, not the amount of taxes paid during the period.
Net profit (or income) after taxes: The final “bottom line” profit cleared by the business from all sources during the period covered by the statement. Using this vital figure, stockholders can evaluate management, investors can decide on whether to purchase the company’s stock, and creditors can measure the riskiness of a loan.

The Statement of Cash Flows
The statement of cash flows, which shows the movement of cash through a business, presents the cash receipts and cash payments of a company over a period of time. It complements the income statement by providing information on a company’s liquidity and financial flexibility. It also ex¬plains the change of cash and cash equivalents during a period. (Cash equivalents are short-term, highly liquid investments that are readily convertible to cash amounts, such as short-term Treasury bills, commercial paper and money market funds.) In similar fashion to the balance sheet and the income statement, the statement of cash flows must be prepared annually by every business but may also be done semiannually or quarterly.

Note: Effective for annual financial statements for fiscal years ending after July 15, 1988, the statement of cash flows supersedes the statement of changes in financial position, which the Fi¬nancial Accounting and Standards Board (FASB) formerly required. Not-for-profits, however, are not required to make the switch-over.
By using the statement of cash flows in conjunction with information provided by the balance sheet and the income statement, company owners, creditors and others who use financial state¬ments can assess a company’s ability to generate future net cash inflows, meet debt obligations and pay dividends. The statement should also help in assessing a company’s need for future external financing, as well as the effects of both cash and noncash investing and financing activities on a company’s financial position.

The statement of cash flows is classified by operating, investing and financing activities. (See sample statement on page 8.) Briefly, these are the items contained in a company’s statement of cash flows:

Operating Activities:
Cash received from:
● Sale of goods or services.
● Collections or sales of receivables that arise from the sales of goods and ser-vices.
● Interest on loans and bonds.
● Dividends on equity securities.
● Insurance and lawsuit settlements.
● Refunds from suppliers.
Cash paid to:
● Acquisition of materials for inventory or manufacturing products, or for goods for resale, including payments on trade accounts and notes payable to suppliers.
● Creditors for interest.

● Employees for compensation.
● Governmental agencies for taxes, duties, fees, fines or penalties.
● Customers for refunds.
● Lawsuit settlements.
● Charities for contributions.

Investing Activities:
Cash received from:
● Sales of property, plant, equipment and other productive assets.
● Sales of a business unit such as a branch, division or subsidiary.
● Collections of principal on debt instru¬ments of other companies.
● Sale of loans.

Cash paid to:
● Acquire property, plant, equipment and other productive assets.
● Acquire another business.
● Make loans to and/or purchase loans from another company.
● Acquire debt or equity investments in other companies.
Financing Activities:
Cash received from:

● Issuing equity instruments, such as stock in the company.
● Issuing bonds, mortgages, notes and other forms of short-term or long-term borrowing.
Cash paid to:
● Owners of the company in the form of dividends or other distributions.
● Repayment of amounts borrowed on short-term and long-term debt.


Cash flows from operating activities
Cash received from customers $110,000
Cash paid to suppliers and employees ( 90,000)
Interest received 8,000
Interest paid ( 6,000)
Income taxes paid ( 9,000)
Net cash provided by operating activities $13,000
Cash flows from investing activities
Proceeds from sale of plant
$70,000
Purchase of equipment ( 10,000)
Net cash provided by investing activities $60,000
Cash flows from financing activities
Principal payments on notes ($40,000)
Dividends paid ( 15,000)
Net cash used in financing activities ($55,000)
Net increase in cash and equivalents 18,000
Cash and equivalents at beginning of year 12,000
Cash and equivalents at end of year $30,000
Reconciliation of net profit to net cash provided by operating activities:
Net profit after taxes $37,000

Depreciation 2,000
Gain on sale of plant (11,000)
Increase in trade accounts receivable ( 7,000)
Increase in inventory (10,000)
Decrease in accounts and notes payable 5,000
Increase in interest and taxes payable ( 3,000)
Net cash provided by operating activities $13,000

The most straightforward way to present operating activities in a statement of cash flows is the direct method, which reports major classes of operating cash receipts and payments. Under this method, a separate schedule is presented with the statement of cash flows that reconciles net profit and net cash flow from operating activities. In effect, this reconciliation is a conversion of net profit from the accrual to the cash basis of accounting.

➤ Observation: You’ll find the balance sheet, the income statement and the statement of cash flows in a company’s annual report. In most annual reports these financial statements are pre¬sented on a comparative basis: that is, the current year along with one or more prior years. Use the figures in these statements to analyze your own company as well as your competition, to forecast the financial outcome for your entire business or department project, and to make a variety of other essential business decisions. In short, these reports are three of the businessperson’s most important tools.