Understanding the Income Statement in Accounting

Stock

Something that has been accumulated at a point in time.

Flow

A change in that thing over a period of time.

Income Statement

Summarizes the flows of activities over a period.

Balance Sheet

A financial statement that represents stocks.

Statement of Cash Flows

A financial statement that represents flows.

Revenue

The dollar value of what a company has sold to its customers in a given period.

Revenue Recognition

The process of determining when revenue is earned.

Judgment Calls

Decisions made based on estimates that can lead to distorted or fraudulent accounting.

Channel Stuffing

The illegal practice of shipping more products to a retailer than they can sell to inflate revenue figures.

Ambiguous Revenue

Revenue amounts that are often based on estimates and judgments.

Bill and Hold Scam

A fraudulent accounting practice where revenue is recognized for goods that are not yet delivered.

Phantom Revenues

Revenue that is recorded but does not represent actual sales.

Sales Contract

An agreement that can trigger the recognition of revenue.

Delivery of a Product or Service

The point at which revenue is often recognized for simple products.

Estimates

Calculations that require judgment and can affect the accuracy of financial statements.

Inflow from Sales Revenue

The total revenue generated from sales during a specific period.

Outflows for Expenses

The total costs incurred by a business during a specific period.

Judgment Required

The necessity of making decisions based on subjective criteria in accounting.

SEC Fine

A monetary penalty imposed by the Securities and Exchange Commission for violations.

Criminal Charges

Legal accusations against individuals for committing a crime, such as accounting fraud.

Sales Targets

Goals set for sales performance within a specific timeframe.

Returns from Retailers

Products sent back by retailers, which can affect reported revenue.

Consequences for Cendant Executives

Sentenced to 10+ years in prison and ordered to pay $3.5 billion.

Consequences for RiteAid Executives

Key executives, including the CEO, were sentenced to prison for terms of 8 to 10 years.

Fraudulent Revenue

Incentives for senior executives to mis-state revenue can lead to significant consequences for businesses.

Liability for Bad Financial Statements

Businesses can be sued for damages or prosecuted with criminal charges if financial statements are misleading.

Categories of Expenses

There are three categories of expenses: Cost of Goods Sold (COGS), Operating Expense, and Other Expenses.

Cost of Goods Sold (COGS)

Direct product cost including cost of materials and direct labor costs.

Cost of Services (COS)

Direct service cost typically involving labor associated with delivering the service.

COGS Example for Snickers Bars

Includes chocolate, sugar, peanuts, paper packaging, and labor costs for manufacturing line.

COS Example for Delivery Business

Includes labor cost for delivery people, gas for cars or trucks, and possibly maintenance for cars or trucks.

Direct Costs

Costs that can be physically traced to a finished good or service.

Indirect Costs

Costs that cannot be physically traced to a finished good or service.

Operating Expenses

All non-COGS expenses needed to carry on the normal operating activity of the business.

Selling, General and Administrative (SG&A)

Another term for Operating Expenses.

Variable Costs

Costs that move up and down in proportion with changes in sales volume or sales revenue.

Examples of Variable Costs

Cost of goods sold expense, commissions, franchise fees, transportation costs, and credit/debit card fees.

Fixed Costs

Costs that do not vary much with changes in sales and cannot decrease easily over the short run.

Examples of Fixed Costs

Rent, utilities, property taxes, depreciation expense, and annual insurance costs.

Other Expenses

Includes interest expense, taxes, and one-time charges like inventory write-downs.

Profit

The amount left over after expenses are subtracted from revenue.

Gross profit

Equals revenue minus COGS or COS; it is what is left over after a company has paid direct product, or direct service, costs.

Operating profit

Equals gross profit minus operating expenses; also called Earnings Before Interest and Taxes (EBIT).

Net profit

What's left after all costs and expenses are subtracted from revenue; equals operating profit minus interest expenses, taxes, and one-time charges.

Gross profit margin

Expressed as a percentage; shows, for each dollar of revenue, what percent you keep as profit.

Operating profit margin

Expressed as a percentage; shows, for each dollar of revenue, what percent you keep as profit from normal business operations.

Net profit margin

Expressed as a percentage; shows, for each dollar of revenue, what percent you keep as profit after all expenses.

Gross Profit Margin Percentage

Calculated as gross profit divided by revenue.

Operating Profit Margin Percentage

Calculated as operating profit (or EBIT) divided by revenue.

Net Profit Margin Percentage

Calculated as net profit divided by revenue.

Product gross margin %

Calculated as gross profit divided by price.

Mark Up Percentage

Calculated as gross profit divided by COGS.

Sales revenue

Total income generated from sales before any expenses are deducted.

Cost of goods sold expense (COGS)

Direct costs attributable to the production of the goods sold by a company.

Selling, general and administrative expenses

Expenses that are not directly tied to the production of goods or services.

Interest expense

The cost incurred by an entity for borrowed funds.

Income tax expense

The amount of expense that a company incurs for taxes on its income.

Net income

The total profit of a company after all expenses, including taxes and interest, have been deducted from revenue.

Earnings Before Interest and Taxes (EBIT)

Another term for operating profit, indicating profit before interest and tax expenses.

Bottom line

A term often used to refer to net profit.

Gross profit on each headphone

Calculated as the selling price minus the cost of goods sold for each headphone.

Gross profit margin percentage for headphones

Calculated as $18 (gross profit) divided by $32 (selling price), resulting in 56%.

Other Expenses

the third category of expenses, after COGS and Operating Expenses

Interest expense

the interest you have to pay to the lender on money you have borrowed

Taxes

One time charges

One time charges

e.g. write down inventory which can not be sold

Profit

the amount left over after expenses are subtracted from revenue

Gross profit

equals revenue minus COGS or COS

Operating profit

equals gross profit minus operating expenses

Net profit

what's left after all costs and expenses are subtracted from revenue

Earnings Before Interest and Taxes (EBIT)

Also called Operating Profit

Profit Margins

Three types of profit margins: Gross profit margin, Operating profit margin, Net profit margin

Gross Profit Margin Percentage

gross profit / revenue

Operating Profit Margin Percentage

operating profit (or EBIT) / revenue

Net Profit Margin Percentage

net profit / revenue

Product gross margin %

gross profit / price

Mark Up Percentage

gross profit / COGS

Gross profit margin percentage

shows, for each dollar of revenue, what percent you keep as profit

Operating Margin

equivalent to Operating Profit Margin Percentage

Net Margin

equivalent to Net Profit Margin Percentage

Example of Gross Profit

your company sells headphones for $32, each headphone costs you $14, your gross profit on each headphone is $18

Gross profit margin percentage example

the gross profit margin percentage = $18 / $32 = 56%

Example of Mark Up Percentage

your company makes a board game, which you sell for $28. The cost of each game is $20.

Mark Up Percentage

The mark up percentage = ($28 - $20) / $20 = $8 / $20 = 40%

Gross Margin

In the example, the gross margin = $8 / $28 = 28.6%

Gross Profit Margin

The numerator for both Gross Margin % and the Mark Up % is the gross profit.

Denominator for Gross Margin %

The denominator for Gross Margin % is the sales price (or revenue).

Denominator for Mark Up %

The denominator for Mark Up % is COGS.

Profitability Ratios

Gross margin is one of the most important measures for an entrepreneur to measure and manage.

Importance of Gross Margin

Shows the relationship between a product's price and its cost, directly impacting the profitability of your business.

True Religion Phantom Jeans

Projected wholesale price = $150.

High Margin Businesses

Businesses with high gross margins are less vulnerable to failure.

High Gross Margin Characteristics

High gross profit margins can reflect pricing power due to unique product or strong branding.

Apple vs. HP Gross Margin

Apple gross margin = 43%, HP gross margin = 24%.

Good Gross Margin

In general, gross margins of 35% and above are considered to be very good.

Supermarkets Gross Margins

Supermarkets generally have low margins, ranging from 10% to 25%.

Pharmaceutical Products Gross Margins

Patented pharmaceutical products can have gross margins of 90%.

Competing in Low Gross Margin Businesses

Operational excellence requires minimizing management mistakes and waste.

Maximizing Gross Margins

Maximizing gross margins requires a dual focus on pricing strategy and cost management.

Factors in Setting Price

Factors include uniqueness of product or service, branding and marketing, competition, patent protection, and market segmentation.