BMSH2003 Income Statement, Owner's Equity, and Cash Flows

Income Statement and Profitability Analysis

• Information on performance and profitability is primarily provided in the statement of comprehensive income. This information is essential for assessing potential changes in the economic resources, specifically assets, that an enterprise is likely to control in the future.

• The statement allows decision-makers to predict the capacity of an enterprise to generate cash flows from its existing resource base. It also aids in forming judgments about how effectively the enterprise might employ additional resources.

• Reliability of Profitability: Many investors and creditors perceive profitability information as the most useful indicator for predicting future profitability and future cash-generating ability.

• Historical Significance: Since the late 1960s to 1970s, the income statement has been widely perceived as the single most significant financial statement of an enterprise.

• Specific User Perspectives:

  • Creditors: Refer to the income statement to gain insights into the ability of a debtor to generate future cash flows from operations required to repay obligations.

  • Investors: Consider past income as a useful predictor of future earnings and the best indicator of future dividends and market price behavior.

  • Management: Uses the income statement as a gauge of effectiveness and efficiency in utilizing company resources.

  • Lifeblood status: Profit is the lifeblood of any enterprise organized to earn a satisfactory return on the capital invested by owners.

• Defining the Income Statement:

  • Also known as the Statement of Comprehensive Income, the profit or loss statement, or the statement of earnings.

  • It measures financial performance or the success of company operations for a given period.

  • It is used to determine profitability, investment value, and creditworthiness, helping predict the amounts, timing, and uncertainty of future cash flows.

Usefulness of the Income Statement

• Evaluates past performance: Examining revenues and expenses indicates how the company performed and allows for comparison against competitors. For instance, analysts use data from Hyundai (KOR) to compare its performance against Toyota (JPN).

• Basis for predicting future performance: Information about past performance helps determine important trends. For example, General Electric (GE) (USA) once reported consistent increases in revenues. While past success does not guarantee future success, a reasonable correlation between past and future performance allows analysts to better predict future revenues, earnings, and cash flows.

• Assessing risk and uncertainty: Components of income—revenues, expenses, gains, and losses—highlight relationships that help assess the risk of not achieving specific future cash flows. For example, investors often segregate operating performance from discontinued operations because continuing operations have greater significance for predicting future performance.

Approaches to Measuring Profit

• Capital Maintenance Approach: This approach measures profit or net income as the excess of ending capital over beginning capital after excluding owner transactions.

  • Calculation:     $Capital (net assets), end of the year$     $Minus: Capital (net assets), beginning of the year$     $Equals: Change in capital during the year$     $Add: Dividends declared$     $Less: Additional Investments$     $Equals: Profit for the year$

  • Note: Dividends are added back and additional investments are deducted to eliminate their effects on capital. This approach is generally unacceptable for financial reporting because it lacks a breakdown identifying the causal relationships and operating activities comprised in the profit amount.

• Transaction Approach: Profit is measured as the difference between total income and total expenses for a reporting period based on recorded transactions. It utilizes the accrual basis of accounting.

  • Formula: $Profit = Income - Expenses$

  • This approach provides a detailed classification of profit into revenues/gains and expenses/losses, helping users assess future performance and cash flow generation.

Elements of the Income Statement

• The Conceptual Framework identifies two elements of enterprise performance:

• 1. Income: Increases in economic benefits during the accounting period in the form of inflows, enhancements of assets, or decreases in liabilities that result in equity increases (excluding contributions from equity participants).

  • a. Revenues: Arise from central or major revenue-producing activities. Examples include Sales Revenue for retailers and manufacturers, or Service Revenue/Professional Fees for service providers.

  • b. Gains: Arise from incidental transactions to company operations.

• 2. Expenses: Decreases in economic benefits during the accounting period in the form of outflows, depletions of assets, or incurrence of liabilities that result in equity decreases (excluding distributions to equity participants).

  • a. Expenses: Result from central or major revenue-producing activities (operating expenses).

  • b. Losses: Result from incidental transactions.

Comparative Income Statement Formats

• Businesses choose between two formats depending on the business type and the purpose of the statement.

• Single-Step Income Statement:

  • Uses only one subtraction to arrive at net income: total expenses deducted from total revenues.

  • Heading Requirements:

  • 1. Name of the Company.

  • 2. "Income Statement".

  • 3. Time interval (e.g., "For the Year Ended December 31, 201A").

  • Preparation Steps:

  • 1. List income accounts and amounts in the rightmost section.

  • 2. List total costs and expenses in a separate column to the left.

  • 3. Compute total costs and expenses.

  • 4. Deduct total costs/expenses from income to find Net Income or Net Loss.

  • 5. Draw double lines below totals.

• Multiple-Step Income Statement:

  • Uses multiple subtractions to calculate net income.

  • Separates operating revenues and expenses from non-operating ones to distinguish core business activities.

  • Key Definitions:

  • Sales Revenue: Gross revenue from sales/services at the top of the statement.

  • Contra-revenue accounts: Deducted from gross sales to find Net Sales. Includes Sales Discount (early payment rewards) and Sales Returns and Allowances (for defective/damaged goods).

  • Net Purchases Formula: $Purchases + Freight-in - (Purchase Returns + Allowances + Discounts)$

  • Cost of Goods Sold (COGS): Also called "puhunan" in Filipino, representing the direct costs of merchandise sold.

  • Gross Profit: Net Sales minus Cost of Goods Sold.

  • Operating Expenses: Categorized into General/Administrative Expenses (home office utilities, admin salaries) and Selling Expenses (sales commissions, delivery, advertising).

Statement of Changes in Owner's Equity

• This statement identifies changes in asset and liability balances arising from transactions with equity participants. It links the Statement of Financial Position and the Statement of Comprehensive Income.

• Information includes effects from operations, contributions from owners, and distributions to owners.

• Terminology by Business Type:

  • Sole Proprietorship: Statement of Owner's Equity.

  • Partnership: Statement of Partners' Equity.

  • Corporation: Statement of Stockholders' Equity.

• Component Logic (Sole Proprietorship Example):

  • $Capital, January 1$

  • $Plus: Net Income (or minus Net Loss)$

  • $Plus: Additional Investment$

  • $Minus: Withdrawals$

  • $Equals: Capital, December 31$

• Corporation Components:

  • Includes Ordinary Share Capital (Common Stock), Preference Share Capital (Preferred Stock), Share Premium (Additional Paid-in Capital), and Retained Earnings (profits not yet declared as dividends).

The Statement of Cash Flows

• The balance sheet and income statement provide limited information regarding actual cash receipts and payments. The Statement of Cash Flows (SCF) reports cash receipts, payments, and net changes in cash resulting from operating, investing, and financing activities.

• Usefulness of SCF:

  • Assesses the entity's ability to generate future cash flows.

  • Assesses the ability to pay dividends and meet obligations.

  • Explains the difference between net income and net cash provided by operating activities (addressing concerns about accrual-basis estimates).

  • Details cash investing and financing transactions to show why assets and liabilities changed.

• Cash and Cash Equivalents:

  • Cash equivalents are short-term, highly liquid investments with a maturity of $90$ days or less from the purchase date. Examples include Money market accounts, Commercial paper, and Treasury bills.

  • Transactions between cash and cash equivalents are not considered cash flow activities.

• Three Categories of Activity:

  • 1. Operating Activities: Primary revenue-producing activities which enter into the determination of net income (e.g., cash from customers, payments to suppliers/employees, interest payments).

  • 2. Investing Activities: Making and collecting loans, and acquiring/disposing of investments and PPE (Property, Plant, and Equipment).

  • Negative cash flow here implies the acquisition of long-term assets for future growth.

  • Positive cash flow may indicate downsizing or divestment.

  • 3. Financing Activities: Obtaining resources from owners (e.g., issuing shares), providing returns (dividends), and borrowing/repaying creditors (long-term debt).

Preparation of the Statement of Cash Flows (Direct vs. Indirect)

• Direct Method: Reports major classes of gross cash receipts and payments. It is preferred by IAS 7 and the FASB for providing better estimates of future cash flows.

  • Key Adjustments Example (Exodus Company):

  • Cash Received from Customers: $Sales Revenue (590,000) - Increase in Accounts Receivable (20,000) = 570,000$.

  • Cash Paid to Suppliers:

    • Step 1: Compute Purchases: $COGS (300,000) + Increase in Inventory (14,000) = 314,000$.

    • Step 2: Compute Cash Payment: $Purchases (314,000) + Decrease in Accounts Payable (5,000) = 319,000$.

  • Cash Paid for Interest: $Interest Expense (7,000) + Decrease in interest payable (1,000) = 8,000$.

  • Cash Paid for Income Taxes: $Income Tax Expense (15,000) - Increase in income tax payable (10,000) = 5,000$.

• Indirect Method: Adjusts net income to arrive at net cash from operations. Most accountants prefer this for ease of preparation.

  • Adjustments include adding back non-cash expenses like Depreciation ($24,000$) and Losses on sale of assets ($6,000$).

  • Gains on retirement of debt ($16,000$) are subtracted from net income.

  • Working Capital Changes:

  • Deduce from net income: Increases in current assets and decreases in current liabilities.

  • Add to net income: Decreases in current assets and increases in current liabilities.

Financial Statement Analysis and Interpretation

• Financial Statement (FS) analysis involves selecting data to evaluate a firm's past performance, present condition, and future potential. Objectives include assessing Profitability, Solvency, Safety of investment, and Management effectiveness.

• Limitations of FS Analysis:

  • 1. Comparability: Differences in accounting methods and estimates between companies.

  • 2. Valuation: Financial statements rely on historical costs, failing to reflect current market values or inflation.

  • 3. Ratio limitations: Ratios are starting points, not ends. Analysis must include internal factors (employee growth, customer satisfaction) and external factors (industry trends, technology, economic indicators).

• Analytical Techniques:

• 1. Horizontal Analysis (Trend Analysis): Analyzing data over time. Each item is compared with a base year to compute peso and percentage changes.

  • $Peso Change = Most Recent Value - Base Period Value$

  • $Percentage Change = \frac{Most Recent Value - Base Period Value}{Base Period Value} \times 100$

• 2. Vertical Analysis (Common-Size Statements): Focuses on relationships at a specific point in time. Each item is expressed as a percentage of a base:

  • Balance Sheet base: Total Assets.

  • Income Statement base: Net Sales.

Comprehensive Financial Ratios Encyclopedia

• I. Liquidity Ratios: Monitor current assets relative to current liabilities.

  • 1. Net Working Capital: $Current Assets - Current Liabilities$. Ensures ability to pay creditors.

  • 2. Current Ratio: $\frac{Current Assets}{Current Liabilities}$. Basic test of liquidity; 2.0 often preferred.

  • 3. Quick Ratio (Acid-Test): $\frac{Quick Assets}{Current Liabilities}$. A severe test excluding inventory/prepayments. 1.0 is acceptable.

• II. Asset Management (Utilization) Ratios: Measure effectiveness in using assets to generate revenue.

  • 1. Accounts Receivable Turnover: $\frac{Net Credit Sales}{Average Accounts Receivable}$. Efficiency of collections.

  • 2. Average Collection Period: $\frac{365 days}{Accounts Receivable Turnover}$. Average days to collect.

  • 3. Inventory Turnover: $\frac{Cost of Goods Sold}{Average Inventory}$. Speed of inventory conversion to sales.

  • 4. Number of Days in Inventory: $\frac{365 days}{Inventory Turnover}$. Average days inventory is held.

  • 5. Fixed Assets Turnover: $\frac{Net Sales}{Average Net Fixed Assets}$. Use of PPE to generate sales.

  • 6. Total Assets Turnover: $\frac{Net Sales}{Average Total Assets}$. Effectiveness of total investment.

• III. Solvency Ratios (Financial Leverage): Measure ability to use debt to maximize shareholder value.

  • 1. Debt-to-Equity: $\frac{Total Liabilities}{Total Stockholders' Equity}$. Relative contribution of creditors vs owners.

  • 2. Debt Ratio: $\frac{Total Liabilities}{Total Assets}$. Share of creditors over total resources.

  • 3. Equity Ratio: $\frac{Total Stockholders' Equity}{Total Assets}$. Resources provided by owners.

  • 4. Times-Interest-Earned (TIE): $\frac{EBIT}{Interest Expense}$. Ability to meet annual interest payments.

• IV. Profitability Ratios: Measure operating effectiveness and recovery of investments.

  • 1. Profit Margin on Sales (ROS): $\frac{Net Income}{Net Sales}$. Profit percentage per peso of sales.

  • 2. Gross Profit Ratio: $\frac{Gross Profit}{Net Sales}$. Percent available to cover operating expenses.

  • 3. Return on Assets (ROA): $\frac{Net Income}{Average Total Assets}$. Overall profitability of employed assets.

  • 4. Return on Equity (ROE): $\frac{Net Income}{Average Stockholders' Equity}$. Income derived for every peso of owner's equity.