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How to Read Income Statement

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How to Read an Income Statement Table of Contents 1. Introduction to Income Statement Analysis

2. Sample Income Statement

3. Revenue and Sales on the Income Statement 4. Cost of Goods Sold

5. Gross Profit

6. Calculating Gross Profit Margin

7. Analyzing the First Three Lines of the Income Statement 8. Operating Expenses

9. Research and Development Costs (R&D)

10. Selling, General, and Administrative Expense - SGA Expenses 11. Goodwill and Amortization Expense

12. Extraordinary Events

13. Accounting for Extraordinary and Non-Recurring Events 14. Calculating Operating Income and Operating Margin 15. Interest Income and Expense

16. Interest Coverage Ratio 17. Depreciation Expense 18. Accumulated Depreciation 19. Straight Line Depreciation

20. Sum of the Years Digits and Accelerated Depreciation Methods 21. Double Declining Balance Depreciation Method

22. Comparing Depreciation Methods 23. EBITDA

24. Income Taxes

25. Accounting for Minority Interest on the Income Statement 26. Unreported or Look-Through Earnings

27. Continuing Operations vs. Discontinued Operations 28. Accounting Changes

29. Preferred Dividends on the Income Statement 30. Net Income Applicable to Common Stock 31. Calculating Net Profit Margin

32. Basic EPS vs. Diluted EPS 33. Hiding Share Dilution 34. Share Repurchases 35. Return on Equity - ROE 36. Asset Turnover

37. Return on Assets - ROA 38. Projecting Earnings

39. Formulas and Calculations 40. Putting It All Together

41. Sample Real World Income Statement Analysis - Abercrombie & Fitch 42. Sample Income Statement Analysis - Brown Safety Company

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Investing Lesson 4: Income Statement

Analysis

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Sit back in your chair, take out a copy of an annual report or 10K, flip to the consolidated income statement for the most recent year, and let’s begin working through it. In the end, I think you’ll be surprised by how much you’ve learned. Towards the end of this lesson, we will actually work through Abercrombie & and Brown Safety's income statements. As always, there will be quiz following the lesson. You should be able to pass without missing more than two questions. Next page > A sample income statement > Page 1, 2, 3, 4, 5, 6, 7, more >>

The best way to learn to read an income statement is to begin by looking at a real world example. In this case, I'm going to take an old income statement from Microsoft because it is relatively simple, enough time has passed for us to look at the figures in retrospect, and you can look at it to get an idea of what an ordinary income statement looks like. You can see this sample at the bottom of this page. You may want to print it for reference as you work your through this lesson. It's important to note that not all income statements look alike, although they necessarily contain much of the same information. As we work our way through various income statements, you will inevitably find they are much simpler and comparable than may appear at first glance.

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Sample Income Statement

Microsoft Income Statement

Fiscal year 2001 2000 1999

Total Revenue $28,365,000,000 $$25,296,000,000 $$22,956,000,000 Cost of Goods Revenue $5,191,000,000 $3,455,000,000 $3,002,000,000 Gross Profit $23,174,000,000 $21,841,000,000 $$19,954,000,000 Operating Expense

Research and Development $4,307,000,000 $4,379,000,000 $3,775,000,000 Selling, General, and Administrative

Expenses $6,957,000,000 $5,742,000,000 $5,242,000,000

Non Recurring N/A N/A N/A

Other Operating Expenses N/A N/A N/A

Operating Income

Operating Income $11,910,000,000 $11,720,000,000 $10,937,000,000 Total Other Income and Expenses Net ($397,000,000) ($195,000,000) $3,338,000,000 Earnings Before Interest and Taxes $11,513,000,000 $11,525,000,000 $14,275,000,000

Interest Expense N/A N/A N/A

Income Before Taxes $11,513,000,000 $11,525,000,000 $14,275,000,000 Income Tax Expense $3,684,000,000 $3,804,000,000 $4,854,000,000 Equity Earnings or Loss Unconsolidated

Subsidiary N/A N/A N/A

Minority Interest N/A N/A N/A

Net Income from Continuing

Operations $7,829,000,000 $7,721,000,000 $9,421,000,000

Nonrecurring Events

Discontinued Operations N/A N/A N/A

Extraordinary Items N/A N/A N/A

Effect of Accounting Changes N/A ($375,000,000) N/A

Other Items N/A N/A N/A

Net Income $7,829,000,000 $7,346,000,000 $9,421,000,000

Next page > Let's start walking through the income statement ... > Page 1, 2, 3, 4, 5, 6, 7, more >>

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Total Revenue or Total Sales

The first line on any income statement is an entry called total revenue or total sales. This figure is the amount of money a business brought in during the time period covered by the income statement. It has nothing to do with profit. If you owned a pizza parlor and sold 10 pizzas for $10 each, you would record $100 of revenue regardless of your profit or loss.

The revenue figure is important because a business must bring in money to turn a profit. If a company has less revenue, all else being equal, it's going to make less money. For startup companies and new ventures that have yet to turn a profit, revenue can sometimes serve as a gauge of potential profitability in the future.

Many companies break revenue or sales up into categories to clarify how much was generated by each division. Clearly defined and separate revenues sources can make analyzing an income statement much easier. It allows more accurate predictions on future growth. Starbucks' 2001 income statement is an excellent example (see Table STAR-1 at the bottom of this page). As you see in the chart, sales at Starbucks come primarily from two sources: retail and specialty. In the annual report, management explains the difference between the two several pages before the income statement. "Retail" revenues refer to sales made at company-owned Starbucks stores across the world. Every time you walk in and order your favorite coffee, you are adding $3 to $5 in revenue to the company's books. "Specialty" operations, on the other hand, consists of money the company brings in by sales to "wholesale accounts and licensees, royalty and license fee income and sales through its direct-to-consumer business". In other words, the specialty division includes money the business receives from coffee sales made directly to customers through its website or catalog, along with licensing fees generated by companies such as Barnes and Nobles, which pay for the right to operate Starbucks locations in their bookstores.

Table STAR-1

Starbucks Coffee

Consolidated Statement fo Earnings - Excerpt Page 29, 2001 Annual Report

In thousands except earnings per share Fiscal year ended Sept 30, 2001 Oct 1, 2000 Net Revenues

Retail $2,229,594 $1,823,607

Specialty $419,386 $354,007

Total net revenues $2,648,980 $2,177,614

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Cost of Revenue, Cost of Sales, Cost of Goods Sold (COGS)

Cost of goods sold (COGS for short) is the expense a company incurred in order to manufacture, create, or sell a product. It includes the purchase price of the raw material as well as the expenses of turning it into a product. Cost of goods sold (COGS) is also known as cost of revenue or cost of sales.

Going back to our pizza parlor example, your cost of goods sold (COGS) include the amount of money you spent purchasing items such as flour and tomato sauce.

The cost of goods sold per dollar of sales is going to be different depending upon the type of business you own or in which you buy shares of stock. A licensing company or law firm will have virtually no cost of goods sold because they are selling a service and not a tangible product. Before you invest in a business, you'll want to research the industry you are examining and find out what is considered "good". For corporations that drill for oil, for instance, one of the most important figures you need to consider is the cost per barrel to get the oil out of the ground. This is, in effect, the cost of goods sold for the oil company. If one firm can get crude at far lower costs than its competitors, it has a distinct advantage and will result in more profit flowing to the owners or shareholders.

Another thing you want to try and figure out is how exposed a company is to a particular input cost. For Southwest Airlines, the cost of jet fuel (and thus, oil) is the most important cost the company has. For Starbucks or Folgers, now a division of J.M. Smucker's, it's coffee. For Coca-Cola, sugar prices are extremely important. One of the reasons some investors are extremely successful is because they know the exact relationship between profits and cost of goods sold. It's been noted that Warren Buffett knows the per 12 ounce can profitability figures for a serving of Coca-Cola and watches sugar prices regularly. If you were a small candy company, or even a giant like Coke, periods of time such as April to July of 2009 would have been hard for your business as sugar prices nearly doubled without warning. As an investor, you need to be aware of the risk a business faces due to unexpected higher cost of goods sold regardless of if you are buying shares of stock, purchasing a local business, or launching your own start-up.

Next page > Gross profit on the income statement ... > Page 1, 2, 3, 4, 5, 6, 7, more >> Gross Profit

The gross profit is the total revenue subtracted by the cost of generating that revenue. In other words, gross profit is sales minus cost of goods sold. It tells you how much money a business would have made if it didn’t pay any other expenses such as salary, income taxes, office supplies, electricity, water, rent, etc.

When you look at an income statement, GAAP rules require that gross profit be broken out and clearly labeled as its own line so you can't miss it. Still, you should know how to calculate it for yourself so here is the formula:

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The gross profit figure is important because it is used to calculate something called gross margin, which we will discuss in a moment. In fact, you can't really look at gross profit on its own and know if it is "good" or "bad", making the gross margin even that much more important.

An Example of Gross Profit from One of My Companies

To help illustrate the concept of gross profit, I'll give you an example from one of the businesses in which I have a substantial ownership stake. The company is called Kennon & Company. It sells a lot of luxury shaving sets both online and through its flagship retail store in Kansas City. If a customer purchases an imported British luxury shaving set for $315, our cost of goods sold would typically be $160 for the set itself, $20 for various merchant fees, service charges, and bank processing costs, and $20 for shipping and handling into our retail store.

This results in revenue of $315 - cost of goods sold of roughly $200 for a gross profit of $115 per every shaving set sold. If we were to drop the price 20% for a sale, the calculation would change to $252 revenue - $200 costs of goods sold = $52 gross profit. The $115 in the first case, or the $52 in the second, is the money we have available to pay our sales associates, taxes, office supply expense, and computer costs. The higher the gross profit, the more money we have for expansion, salaries, or dividends to shareholders.

For more advanced readers who own a business or want to understand how to analyze gross profit margins for companies in which they wish to buy stock, I wrote an essay called A Deeper Look at Gross Profit and Gross Profit Margins explaining how it is possible for a company with

low gross profit margins to make more money than a company with high gross profit margins. It

is definitely worth reading.

Next page > Calculating Gross Margin > Page 1, 2, 3, 4, 5, 6, 7, more >>

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To calculate gross profit margin, use this formula: Gross Profit ÷ Total Revenue

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Assume the average golf supply company has a gross margin of 30%. (You can find this sort of industry-wide information in various financial publications, online finance sites such as

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We can take the numbers from Greenwich Golf Supply's income statement and plug them into our formula:

$162,084 gross profit ÷ $405,209 total revenue = 0.40

The answer, .40 (or 40%), tells us that Greenwich is much more efficient in the production and distribution of its product than most of its competitors.

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For more advanced readers who own a business or want to understand how to analyze gross profit margins for companies in which they wish to buy stock, I wrote an essay called A Deeper Look at Gross Profit and Gross Profit Margins explaining how it is possible for a company with

low gross profit margins to make more money than a company with high gross profit margins. It

is definitely worth reading.

Next page > Analyzing the first three lines ... > Page 1, 2, 3, 4, 5, 6, 7, more >> Table GGS-1

Greenwich Golf Supply

Consolidated Statement of Earnings - Excerpt In thousands except earnings per share Fiscal year ended Sept 30, 2007 Oct 1, 2008 Total Revenue $405,209 $315,000 Cost of Sales $243,125 $189,000 Gross Profit $162,084 $126,000 Putting It Together Thus Far:

We've actually covered a lot of ground. Here's an example to help reiterate and clarify everything we've discussed about the income statement.

If the owner of an ice cream parlor purchased 10 gallons of vanilla ice cream for $2 per gallon, and sold each of those gallons to her customers for $5, the first three lines on her income statement would look something like this:

Total Revenue $50

(The total revenue is the amount of money rung up at the cash register. The owner sold 10 gallons of vanilla ice cream to her customers for $5 per gallon. 10 gallons x $5 a gallon = $50.) Cost of Goods Sold $20

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Gross Profit $30

(The total revenue subtracted by the cost to earn that revenue is $30. Before taxes, and other expenses, this is the ice cream parlor's gross profit.)

Gross Margin: .6 (or 60%)

The gross margin of 60% means that for every $1 the company generates in sales, it is going to be left with $0.60. That sixty cents must be enough to cover all of the other expenses such as payroll, rent, taxes, freezers, cash registers, aprons, security systems, and accounting fees, just to name a few, before the owner will receive any dividend income from the business. Those other expenses are known as operating expenses and that's what we're going to examine on the next page.

Next page > Operating expenses ... > Page 1, 2, 3, 4, 5, 6, 7, more >> Operating Expense

The next section of the income statement focuses on the operating expenses that arise during the ordinary course of running a business. Operating expense consists of salaries paid to employees, research and development costs, legal fees, accountant fees, bank charges, office supplies, electricity bills, business licenses, and more.

The general rule of thumb is that if an expense doesn't qualify as a cost of goods sold, meaning it isn't directly related to producing or manufacturing a good or service, it goes under the operating expense section of the income statement. There are several categories, the biggest of which is known as Selling, General, and Administrative Expense, but we'll get to that in a few pages. Whether you are a new investor trying to study a company's annual report and 10K, or a business owner examining your operations or considering buying or starting a new undertaking,

understanding the role of operating expenses is vital to your success.

The biggest challenge to controlling operating expenses is a risk known as agency cost. It is the inherent conflict between owners and managers. Those that work in the business are always going to want nicer offices, more secretaries, better facilities, faster computers, free lunches, or whatever else they can imagine. These are easier to control if you have a small business but your options are limited if you own shares in a large corporation.

You'll also find that some companies purposely chose to run higher expense ratios than their competitors. One major, well-known bank makes an intentional choice to run 10% to 15% higher operating expenses, and thus lower profit margins, to keep the branches fully staffed. They believe that by making banking as convenient as possible and avoiding long lines, the improved customer service will cause more of their clients to keep a larger portion of their household's accounts with them. Their goal is to eventually become a one-stop shop so that you can do your banking, manage your credit cards, open a brokerage account, or get insurance, all on an

integrated statement. Only you, as the investor, can decide whether you think the plan is intelligent and the higher operating expense are worth it.

In general, you want to work with managements that strive to keep operating expense as low as possible while not damaging the underlying business.

Next page > Research and development costs ... > Page <<back, 8, 9, 10, 11, 12, 13, 14, more >>

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Research and Development

R&D costs can range from nothing to billions of dollars, depending upon the type of business you are analyzing. Unlike many other costs (such as income taxes), management is almost entirely free to decide how should be spent on research and development. In 2001, Eli Lilly, one of the world's largest pharmaceutical companies, plowed nearly 26% of the total gross profit back into R&D.

How much should a company spend on R&D? It depends. In highly creative and fast-moving industries, the amount of money spent on the research and development budget can literally determine the future of the business. If Eli Lilly stopped funding the development of new drugs, its future profitability would suffer, causing a perhaps permanent decline in earnings. In such cases, it may be appropriate to compare the level of R&D funding to profitability over time, as well as to the percentage of gross profit competitors spend on research and development. Next page > Selling, General, and Administrative Expenses ... > Page <<back, 8, 9, 10, 11, 12, 13, 14, more >>

Selling General and Administrative Expenses (SGA)

SGA expenses consist of the combined payroll costs (salaries, commissions, and travel expenses of executives, sales people and employees), and advertising expenses a company incurs. High SGA expenses can be a serious problem for almost any business. A good management will often attempt to keep SGA expenses limited to a certain percentage of revenue. This can be

accomplished through cost-cutting initiatives and employee lay-offs.

There have been several cases in the past where bloated selling, general and administrative expenses have literally cost shareholders billions in profit. According to Roger Loweinstein, in the 1980's, ABC (later merged with CAP Cities, then bought by Disney) was spending $60,000 a year on florists, as well as providing stretch limos and private dining rooms for its executives. It was the shareholders who were footing the bill. (On a related note: at the same time these ABC executives were squandering shareholders' capital, they were artificially padding earnings by selling the original Jackson Pollack and Willem de Kooning paintings the network owned!) SGA Expenses and Fixed vs. Variable Cost Structure

There is a big difference between a company that has a variable cost structure and one that has a

fixed cost structure. A company with high fixed expenses is said to have high operating leverage

because the company loses money up to a break-even point and then makes a lot of profit beyond that level. A perfect example is a McDonald's franchise. Due to the high initial investment in land, building, cooking equipment, restaurant seating, fixtures, and other costs, you may have to do, say, $800,000 to $1,000,000 or more to breakeven. Beyond that point, your costs are covered so you generate far higher profits. That's why a business can fail if sales fall from $2,000,000 to $800,000, even though it is still a decent size by small business standards.

A variable cost structure is one in which the selling, general and administrative expenses keep pace with sales. Think of a furniture importer that has almost no expenses except for a 15% commission paid to independent road salesmen. If sales fall, costs fall in line, protecting the business and shareholders. Companies with highly variable cost structures are said to have low operating leverage.

Next page > Goodwill and Amortization Expense ... > Page <<back, 8, 9, 10, 11, 12, 13, 14, more >>

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Goodwill and other Intangible Asset Amortization Charges

You already learned what goodwill was in Investing Lesson 3 - How to Analyze a Balance Sheet. A quick reminder in case you forgot: Goodwill is used to show the price in excess of the assets one business pays when it acquires another business. If that sentence scared you, calm down and let me explain. Say your pizza parlor wants to buy a competitor's pizza shack. Anything you pay in excess for the current value of the assets such as real estate, food

equipment, appliances, tables, chairs, or other goods, gets put on your balance sheet as goodwill. For more than one hundred years, small business owners often refer to goodwill as "blue sky". In the past, companies were required to charge a portion of goodwill to the income statement, reducing reported earnings. The theory made sense on the surface: If you bought any asset, you had to depreciate it so why, then, wouldn't you have to do the same when you bought an entire company?

For all intents and purposes, these goodwill charges were ignored by the investor because, unlike buying assets that were needed to operate, acquiring a competitor or merger likely increased your profits if done wisely. The goodwill charges were causing managers to report lower earnings, which was against the accounting goal of providing an accurate picture of economic reality.

Changes in the Accounting Rules for Goodwill

In June 2001, the Financial Accounting Standards Board (FASB), the folks who make

accounting rules in the United States by determining GAAP, changed the guidelines, no longer requiring companies to take these goodwill and amortization charges. Instead, the company was required to periodically determine, through cash-flow analysis and other means, whether the goodwill was impaired. In practical terms, this meant that the goodwill would sit on the balance sheet forever unless something happened to the acquired business that caused management to realize they overpaid. In the event they did overpay, they would record a goodwill expense on the income statement, causing reported profits to fall. The goodwill "asset" could then be removed from the balance sheet.

The one exception to this new goodwill policy was intangible assets that do not have indefinite lives, such as patents. These will need to continue to be amortized off as an expense because when the patent expires, it is effectively worthless so it would be misleading to list it on the balance sheet as an asset. In simple terms, if the pizza shack you bought had a licensing agreement with a local sports team that ran out in five years, you would have to continue to charge that asset off on the income statement until it reached $0 at the end of the five years. The most important thing for you to know when you look at goodwill is that it is a non-cash charge. That means that if a company has a goodwill expense of $10 million, not a penny is coming out of headquarters in most cases because it is just representing a loss that has already occured. If the pizza shack you bought went bankrupt three years from now after the building burned to the ground, you would record a goodwill charge and your profits will be lower. The money you spent for the building was paid out three years before when you bought the place, not when the goodwill charge hit the income statement.

Next page > Extraordinary Events ... > Page <<back, 8, 9, 10, 11, 12, 13, 14, more >> Non-Recurring and Extraordinary Items or Events

You own a successful dry cleaning business. Out of the blue, a tornado sweeps away your storefront and shuts you down for a few months. Your insurance will pay to rebuild but it will

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take time and there are other costs involved. Is the tornado expense a regular, expected occurance? Does it really hurt the value of your business? Of course not.

In the unpredictable world of business, events will arise that are not expected and most likely not occur again. These one-time events are separated on the income statement and classified as either non-recurring or extraordinary. There is a difference between the two, which I'll explain in a moment.

These two categories allow investors to more accurately predict future earnings. If, for instance, you were considering purchasing a gas station, you would base your valuation on the earning power of the business, ignoring one-time costs such as replacing the station's windows after a thunderstorm. Likewise, if the owner of the station had sold a vintage Coke machine for $17,000 the year before, you would not include it in your valuation because you had no reason to expect that profit would be realized again in the future.

The Difference Between Non-Recurring and Extraordinary Events on the Income Statement

What is the difference between non-recurring and extraordinary events?

Non-Recurring Event: A non-recurring eventis a one-time charge that the company doesn't expect to encounter again. An extraordinary item is an event that materially* affected a company's finance and needs to be thoroughly explained in the annual report or SEC filings.

Extraordinary Event: Extraordinary events can include costs associated with a merger, or the expense of implementing a new production system (as McDonald's did in the late 1990's with the Made for You food preparation system).

There is an important distinction between the two categories: Non-recurring items are recorded

under operating expenses, while extraordinary items are listed after the net line, after-tax.

* The term material is not specific. It generally refers to anything that affects a company

in a meaningful and significant way. Some investors try to put a number on the figure,

saying an event is material if it causes a change of 5% or more in the company's finances.

Next page > Accounting for extraordinary events ... > Page <<back, 8, 9, 10, 11, 12, 13, 14, more >>

Accounting for Extraordinary and Non-Recurring Items or Events in Your Analysis When calculating a company's earning-power, it is best to leave one-time events out of the equation. These events are not expected to repeat in the future, and doing so will give you a better idea of the earning power of the company.

If you are attempting to measure how profitable a business has been over a longer period, say five or ten years, you should average in the one-time events to paint a more accurate picture. For example, if a company purchased a building for $1 million in 1990, and sold it for $10 million ten years later in 2000, it is improper to consider the company earned $9 million in profit in the year 2000. Instead, the extraordinary income, in this case, $9 million, should be divided by the number of years it accrued (10 years - 1990 to 2000). Thus, $9 million in extraordinary income divided by 10 years = $900,000 in real estate profits per year.

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Although the income statement will reflect a $9 million one-time profit for the business, the investor should restate the earnings during their analysis by going back and adding $900,000 to each of the years between 1990 and 2000. This will increase the accuracy of a trend line. Since the asset was quietly appreciating during this time, it should be reflected.

However, going forward, when attempting to value the business, you shouldn't include that $900,000 extra income per year because it won't be there in the future. That is why you cannot rely solely on past financial statements to figure out what you should pay for a business or stock. You have to be intelligent and use your understanding of what is really going on with a

company.

Next page > Calculating operating income and operating margin ... > Page <<back, 8, 9, 10, 11, 12, 13, 14, more >>

Operating Income and Operating Profit

Operating income, or operating profit as it is sometimes called, is the total pre-tax profit a business generated from its operations. It is what is available to the owners before a few other items need to be paid such as preferred stock dividends and income taxes (don't worry - we'll cover all of those other things later in this lesson).

Operating income can be used to gauge the general health of a company's core business or businesses. All else being equal, it is one of the most important figures you will ever need to know. The reason is straightforward and intuitive: Unless a firm has a lot of assets that it can sell, any money that will flow to shareholders is going to have to be generated from selling something such as a product or service.

If a company is experiencing declining operating income, there will be less money for owners, expansion, debt reduction, or anything else management hopes to achieve. This is one of the reasons that it is so closely watched by lenders and shareholders. In fact, operating income is used to calculate the interest coverage ratio and operating margin.

Calculating Operating Income

Operating Income = Gross Profit – Operating Expenses

Operating Margin (or Operating Profit Margin) The operating margin is another

measurement of management’s efficiency. It compares the quality of a company’s activity to its competitors. A business that has a higher operating margin than others in the industry is

generally doing better as long as the gains didn't come by piling on debt or taking highly risky speculations with shareholders' money.

The most common reason for high operating margins relative to competitors is a low-cost operating model, which means that a company can deliver merchandise or services to customers at much cheaper prices than competitors and still make money. The classic example is Wal-Mart, which is able to get everything from toothpaste to socks into its store at far lower prices due to the efficiency of its warehouse distribution system. I explained the beauty of a low-cost operating model in The Perils of Commodity-Like Businesses. They are the few, exceptional cases when you can make a lot of money in an otherwise unattractive industry.

Calculating the Operating Margin

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Operating Income ÷ Sales = Operating Margin

Just as you learned with the gross profit margin, what is considered "good" depends on the industry. There is one extremely important thing you must learn, though. I'm serious. Stop what you're doing and focus on this statement: The most important figure is not operating income. It is return on unleveraged equity. That may not make sense to you now, but by the end of the lesson it will. It is possible (though unlikely) for a business that generates 3% operating margins to be more profitable for owners than a business that has 20% operating margins. Again, don't worry about the reason; we'll get to it later. Just realize it. Memorize it. Write it down on some paper. It's that important.

Next page > Interest Income and Expense ... > Page <<back, 8, 9, 10, 11, 12, 13, 14, more >> Interest Income

Companies sometimes keep their cash in short-term deposit investments such as certificates or deposit with maturities up to twelve months, savings account, and money market funds. The cash placed in these accounts earn interest for the business, which is recorded on the income statement as interest income. For some companies, interest income is small or meaningless. For others, such as an insurance company that generates profit by investing the money it holds for policyholders into interest paying bonds, it is a crucial part of the business.

Interest income will fluctuate each year with the amount of cash a company keeps on hand and the general level of interest rates as set by the Federal Reserve (to learn more about how this is done, read The Federal Reserve and Interest Rates.

Interest Expense

Companies often borrow money in order to build plants or offices, buy other businesses,

purchase inventory, or fund day-to-day operations. The borrowed money is converted to an asset on the balance sheet (e.g., if a business borrows $1 million to build a distribution center, the distribution center would add $1 million of assets to the balance sheet after the cash was spent.) The interest a company pays to bondholders, banks, and private lenders, on the other hand, is an expense for which it receives no asset. As a result, interest expense must be accounted for on the income statement.

Some income statements report interest income and interest expense separately, while others report interest expense as "net". Net refers to the fact that management has simply subtracted interest income from interest expense to come up with one figure. In other words, if a company paid $20 in interest on its bank loans, and earned $5 in interest from its savings account, the income statement would only show interest expense - net $15.

The amount of interest a company pays in relation to its revenue and earnings is tremendously important. To gauge the relation of interest to earnings, investors can calculate the interest coverage ratio.

Next page > Interest Coverage Ratio ... > Page <<back, 15, 16, 17, 18, 19, 20, 21, more >> Interest Coverage Ratio

The interest coverage ratio is a measure of the number of times a company could make the interest payments on its debt with its earnings before interest and taxes, also known as EBIT. The lower the interest coverage ratio, the higher the company's debt burden and the greater the

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Interest coverage is the equivalent of a person taking the combined interest expense from their mortgage, credit cards, auto and education loans, and calculating the number of times they can pay it with their annual pre-tax income. For bond holders, the interest coverage ratio is supposed to act as a safety gauge. It gives you a sense of how far a company’s earnings can fall before it will start defaulting on its bond payments. For stockholders, the interest coverage ratio is important because it gives a clear picture of the short-term financial health of a business. To calculate the interest coverage ratio, divide EBIT (earnings before interest and taxes) by the total interest expense.

EBIT (earnings before interest and taxes) ÷ Interest Expense = Interest Coverage Ratio General Guidelines for the Interest Coverage Ratio

As a general rule of thumb, investors should not own a stock that has an interest coverage ratio under 1.5. An interest coverage ratio below 1.0 indicates the business is having difficulties generating the cash necessary to pay its interest obligations. The history and consistency of earnings is tremendously important. The more consistent a company’s earnings, the lower the interest coverage ratio can be.

EBIT has its short comings, though, because companies do pay taxes, therefore it is misleading to act as if they didn’t. A wise and conservative investor would simply take the company’s earnings before interest and divide it by the interest expense. This would provide a more accurate picture of safety, even if it is more rigid than absolutely necessary.

Next page > Depreciation Expense ... > Page <<back, 15, 16, 17, 18, 19, 20, 21, more >> Depreciation and Amortization

There are two different kinds of depreciation an investor must grapple with when analyzing financial statements. They are accumulated depreciation and depreciation expense. Each is unique, though new investors often confused them. In order to understand why they are important and how they work, we must discuss the terms individually.

Depreciation Expense

According to a major brokerage firm, “Depreciation is the process by which a company

gradually records the loss in value of a fixed asset. The purpose of recording depreciation as an expense over a period is to spread the initial purchase price of the fixed asset over its useful life. Each time a company prepares its financial statements, it records a depreciation expense to allocate the loss in value of the machines, equipment or cars it has purchased. However, unlike other expenses, depreciation expense is a "non-cash" charge. This simply means that no money is actually paid at the time in which the expense is incurred.”

An Example of Depreciation Expense

To help you understand the concept, let’s look at an example of depreciation expense:

Sherry’s Cotton Candy Company earns $10,000 profit a year. In the middle of 2002, the business purchased a $7,500 cotton candy machine that it expected to last for five years. If an investor examined the financial statements, they might be discouraged to see that the business only made $2,500 at the end of 2002 ($10k profit - $7.5k expense for purchasing the new machinery). The investor would wonder why the profits had fallen so much during the year.

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Fortunately, Sherry’s accountants come to her rescue and tell her that the $7,500 must be allocated over the entire period it will benefit the company. Since the cotton candy machine is expected to last five years, Sherry can take the cost of the cotton candy machine and divide it by five ($7,500 / 5 years = $1,500 per year). Instead of realizing a one-time expense, the company can subtract $1,500 each year for the next five years, reporting earnings of $8,500. This allows investors to get a more accurate picture of how the company’s earning power. The practice of spreading-out the cost of the asset over its useful life is depreciation expense. When you see a line for depreciation expense on an income statement, this is what it references.

This presents an interesting dilemma. Although the company reported earnings of $8,500 in the first year, it was still forced to write a $7,500 check, effectively leaving it with $2500 in the bank at the end of the year ($10,000 profit - $7,500 cost of machine = $2,500 remaining).

The result is that the cash flow of the company is different from what it is reporting in earnings. The cash flow is very important to investors because they need to be ensured that the business can pay its bills on time. The first year, Sherry’s would report earnings of $8,500 but only have $2,500 in the bank. Each subsequent year, it would still report earnings of $8,500, but have $10,000 in the bank because, in reality, the business paid for the machinery up-front in a lump-sum. This is vital because if an investor knew that Sherry had a $3,000 loan payment due to the bank in the first year, he may incorrectly assume that the company would be able to cover it since it reported earnings of $8,500. In reality, the business would be $500 short.* There have been cases of companies going bankrupt even though they were reporting substantial profits. This is where the third major financial report, the cash flow statement, comes into an investor's analysis. The cash flow statement is like a company’s checking account. It shows how much cash was spent and generated, at what time, and from which source. That way, an investor could look at the income statement of Sherry’s Cotton Candy Company and see a profit of $8,500 each year, then turn around and look at the cash flow statement and see that the company really spent $7,500 on a machine this year, leaving it only $2,500 in the bank. The cash flow statement is the focus of Investing Lesson 5.

Accounting for Depreciation Expense in Your Income Statement Analysis

Some investors and analysts incorrectly maintain that depreciation expense should be added back into a company’s profits because it requires no immediate cash outlay. In other words, Sherry wasn’t really paying $1,500 a year, so the company should have added those back in to the $8,500 in reported earnings and valued the company based on a $10,000 profit, not the $8,500 figure. This is incorrect (honestly, I'm being polite - it's idiotic). Depreciation is a very real expense. Depreciation attempts to match up profit with the expense it took to generate that profit. This provides the most accurate picture of a company’s earning power. An investor who ignores the economic reality of depreciation expense will be apt to overvalue a business and find his or her returns lacking. As one famous investor quipped, the tooth fairy doesn't pay for a company's capital expenditure needs. Whether you own a motorcycle shop or a construction business, you have to pay for your machines and tools. To pretend like you don't is delusional.

*Depreciation expenses are deductible but the tax laws are complex. In many cases, a company will depreciate their assets to the IRS far faster than they do on their income statement, resulting in a timing difference. In other words, a machine may be worth $50,000 on the GAAP financial statements and $10,000 on the IRS tax statements. To adjust for this, accounting rules setup a special $40,000 "deferred tax asset" account on the balance sheet that will naturally work itself out by the time the asset has been fully depreciated down to scrap value. You don't really need to know that for now, but for those of you who get really excited about this sort of thing, I thought I'd throw it in there.

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Accumulated Depreciation

If you purchased a new car for $50,000 and resold it three years later for $30,000, you would have experienced a $20,000 loss on the value of your asset. As you just learned in the last section, a business would write a portion of this loss of value off each year, even though it required no cash outlay, reducing reported profits.

The accounting entry has to be put somewhere on the financial statements. It is kept in a special type of account (known as a contra account) on the balance sheet known as accumulated

depreciation. Frankly, you don't need to worry about that. You just need to know that your balance sheet is going to look like this:

Car Asset - $50,000 value

Accumulated Depreciation - Car - ($20,000 value) Net Asset Value - Car: $30,000

As you can see, the purpose of the accumulated depreciation account is to reduce the carrying value of an assets to reflect the loss of value due to wear, tear, and usage. Companies purchase assets such as computers, copy machines, buildings, and furniture, all of which lose value each day. This depreciation loss must be accounted for in the company's financial statements in order to give shareholders the most accurate portrayal of the economic realty of the business.

If you have trouble understanding the concept of accumulated depreciation, think about the problem this way: If a company bought $100,000 worth of computers in 1989 and never

recorded any depreciation expense, the balance sheet would still show an asset worth $100,000. Do you really think that computers that old, which wouldn't even run today's software, are worth anywhere near that amount? At most, you'd be lucky to get a few hundred dollars for scrap parts. Accumulated Depreciation - Net

When you look at a balance sheet, you aren't going to see the individual assets and many businesses don't even bother to show you the accumulated depreciation account at all. Instead, they show a single line called "Property, Plant, and Equipment - net" it is referring to the fact that the company has deducted accumulated depreciation from the purchase price of the company's assets. To see the amount of those depreciation charges, you will probably have to delve into the annual report or 10K.

Once the asset has become worthless or is sold, both it and the matching accumulated

depreciation account are removed from the balance sheet. Any gain or loss above the book value, or carrying value, is recorded according to specific accounting rules depending on the situation. If, for instance, the car we discussed above sold for $27,000 despite having a carrying value of $30,000, a business would record a $3,000 loss, adjusted for the income tax savings that would result.

Next page > Straight Line Depreciation ... > Page <<back, 15, 16, 17, 18, 19, 20, 21, more >> Straight Line Depreciation Method

The simplest and most commonly used depreciation method, straight line depreciation is

calculated by taking the purchase or acquisition price of an asset subtracted by the salvage value divided by the total productive years the asset can be reasonably expected to benefit the company (called "useful life" in accounting jargon).

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Straight Line Depreciation Calculation

(Purchase Price of Asset - Approximate Salvage Value) ÷ Estimated Useful Life of Asset Example: You buy a new computer for your business costing approximately $5,000. You expect a salvage value of $200 selling parts when you dispose of it. Accounting rules allow a maximum useful life of five years for computers. In the past, your business has upgraded its hardware every three years, so you think this is a more realistic estimate of useful life, since you are apt to

dispose of the computer at that time. Using that information, you would plug it into the formula: ($5,000 purchase price - $200 approximate salvage value) ÷ 3 years estimated useful life

The answer, $1,600, is the depreciation charges your business would take annually if you were using the straight line method.

Next page > Sum of the Years Digits and Accelerated Depreciation Methods ... > Page <<back, 15, 16, 17, 18, 19, 20, 21, more >>

Accelerated Depreciation Methods

Another way of accounting for depreciation expense is to use one of the accelerated methods. These include the Sum of the Year’s Digits and the Declining Balance (either 150% or 200%] methods. These accelerated depreciation methods are more conservative and, in most cases, accurate. They assume that an asset loses a majority of its value in the first several years of use. Sum of the Years Digits

To calculate depreciation charges using the sum of the year’s digits method, take the expected life of an asset (in years) count back to one and add the figures together. Example:

10 years useful life = 10 + 9 + 8 + 7 + 6 + 5 + 4 + 3 + 2 + 1 Sum of the years = 55

In the first year, the asset would be depreciated 10/55 in value (the fraction 10/55 is equal to 18.18%), 9/55 (16.36%) the second year, 8/55 (14.54%) the third year, etc. Going back to our example from the straight-line discussion, a $5,000 computer with a $200 salvage value and 3 years useful life would be calculated as follows:

3 years useful life = 3 + 2 + 1 Sum of the years = 6

Taking $5,000 - $200 we have a depreciation base of $4,800. In the first year, the computer would be depreciated by 3/6ths (50%), the second year, by 2/6 (33.33%) and the third and final year by the remaining 1/6 (16.67%). This would have translated into depreciation charges of $2,400 the first year, $1,599.84 the second year, and $800.16 the third year. The straight-line example would have simply charged $1,600 each year, distributed evenly over the three years useful life.

Next page > Double Declining Balance Depreciation Method ... > Page <<back, 15, 16, 17, 18, 19, 20, 21, more >>

Double Declining Balance Depreciation

The double declining balance depreciation method is like the straight-line method on steroids. To use it, accountants first calculate depreciation as if they were using the straight line method. They then figure out the total percentage of the asset that is depreciated the first year and double it. Each subsequent year, that same percentage is multiplied by the remaining balance to be

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depreciated. At some point, the value will be lower than the straight-line charge, at which point, the double declining method will be scrapped and straight line used for the remainder of the asset’s life (got all that?). An illustration may help.

In our straight-line example, we calculated that a $5,000 computer with a $200 salvage value and an estimated useful life of three years would be depreciated by $1,600 annually. The first year, we have to compare this to the total amount to be depreciated, in this case, $4,800 ($5,000 base - $200 salvage value = $4,800). Dividing $1,600 by $4,800, we discover the straight-line

depreciation charge of $1,600 is 33.33% of the total depreciation amount of $4,800. Using this information, we double the 33.33% figure to 66.67%.

In the first year, we would take $4,800 multiplied by .6667 to get a total depreciation charge of approximately $3,200. In the second year, we would take the same percentage (66.67%) and multiply it by the remaining amount to be depreciated. Continuing with the example, we find that $1,600 is the remaining amount to be depreciated at the start of the second year ($4,800 - $3,200 = $1,600). Multiply 1,600 by .6667 to get $1,066. This is the depreciation charge for the second year – or not! Remember that once the depreciation charges dip below the amount that would be charged using the straight-line method, the double declining balance is scrapped and straight line immediately utilized. The straight line method called for charges of $1,600 per year. Obviously, the $1,066 charge is smaller than the $1,600 that would have occurred under straight line. Thus, the deprecation charge for the second year would be $1,600.

For those of you who love algebra, you may find it easier to use this equation: Double Declining Balance Depreciation Method Formula

Depreciation Base * (2 * 100% / Useful Life of Asset in Years)

Next page > Comparing Depreciation Methods ... > Page <<back, 15, 16, 17, 18, 19, 20, 21, more >>

Comparing Depreciation Methods

To reinforce what we've learned thus far, here's a look at what the depreciation charges for the same $5,000 computer would look like depending upon the method used (the chart is at the bottom of this page).

Obviously, depending upon which method is used by management, the bottom-line reported profits of a company can vary greatly from year to year. The level of attention an investor must give depreciation depends upon the asset intensity of the business he or she is studying. The more asset-intensive an enterprise, the more attention depreciation should be given. In other words, you should understand the depreciation philosophy behind every management team when you are examining businesses that require huge plants, factories, equipment, and capital

expenditure investment. This is much less important when analyzing businesses that are not asset intensive, such as software companies, advertising agencies, or insurance brokers.

If you have two asset intensive businesses, and they are using different depreciation methods, and / or useful lives, you must adjust them so they are on a comparable basis in order to get an accurate picture of how they stack up against each other in terms of profit.

Some managements will report depreciation expense broken out as a separate line on the income statement, while others will be more clandestine about it, including it indirectly through SG&A expenses (for the deprecation costs of desks, for instance). Either way, you should be able to

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garner the information either through the income statement itself or going through the annual report or 10K.

Benjamin Graham's 3 Recommended Depreciation Questions

In the classic 1934 edition of Security Analysis, Benjamin Graham recommended the investor answer three questions when dealing with the effects of deprecation on a business (paraphrased): 1. Is depreciation reflected in the earnings statement? Today this, is a moot point because GAAP accounting rules require that all companies report depreciation. This was not the case in the past. 2. Is management using conservative and (as much as possible) accurate depreciation rates? Accounting rules allow assets to be written off over a considerable time period. Buildings, for example, can be depreciated anywhere from ten to thirty years, resulting in large differences in charges depending upon the time frame a particular business uses. A company's 10K filing should contain information on the depreciation rates employed by the company.

3. Are the cost or base to which the depreciation rates applied reasonably accurate? A company may set unrealistically high salvage values on its assets, thus reducing the amount of

depreciation charges it must take every year. Comparing Depreciation Methods

Comparing Depreciation Methods

Method Year 1 Year 2 Year 3

Straight Line $1,600.00 $1,600.00 $1,600.00 Sum of the Years $2,400.00 $1,599.84 $800.16 Double Declining Balance $3,200.00 $1,600.00 $0.00 Next page > EBITDA ... > Page <<back, 22, 23, 24, 25, 26, 27, 28, 29, more >>

Earnings Before Interest, Tax, Depreciation and Amortization - EBITDA

EBITDA tells an investor how much money a company would have made if it didn't have to pay interest expense on its debt, taxes, or take depreciation and amortization charges. EBITDA is intended to be an indicator of a company's financial performance, not free cash flow as many investor incorrectly assume, originally coming into existence in the 1980's during the leveraged-buyout frenzy that epitomized the era of greed. The measurement has become so popular that many companies will boast charts and graphs of their increased EBITDA within the first five pages of their annual report. Investors, thinking this is wonderful, get excited about the business because it appears to be growing in leaps and bounds.

In its brilliance, Wall Street regrettably forgot one part of the equation: common sense. Companies do have to pay interest, taxes, depreciation, and amortization. Treating these

expenses like they don't exist is the same mentality of the five year old who believes no one can see them when their eyes are closed - while they may enjoy pretending for awhile, the IRS and the banks and bondholders who lent money to the company aren't interested in playing games. When the bills come due, these entities want the money owed to them and can force a company into bankruptcy if they aren't paid.

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Still not convinced? Picture this scenario:

A single man in his mid-twenties, earning $30,000 annually, walks into his local bank to get a loan for a new, top-of-the-line BMW. Each year, he pays $8,100 in taxes, reducing his monthly check from $2,500 to $1,825 (for simplicity sake, let's ignore payroll deductions, etc.) He currently has a mortgage payment of $1,100 per month, and a student loan payment of $200 per month. After paying all of these expenses, he has $525 on which to live*.

The loan officer crunches the numbers and comes up with an estimated monthly payment of $750 for the car. The man pulls out his pen to sign the papers. The loan offer looks in confusion after reviewing his information. "Sir," she says, "you only make $525 a month after payments and taxes! You can't afford this loan. Not only can you not afford the payment, you will then have nothing to live on." The man looks confused, "but I make $2,500 per month before my payments and taxes."

See the fallacy? The gentlemen in our example may ignore the loans, but his creditors surely won't. In fact, the officer would probably laugh at him. Sadly, this is exactly what corporations are doing by presenting their EBITDA numbers to investors.

The truth is, in virtually all cases, EBITDA is absolutely, entirely, and utterly useless. It is simply a way for companies that can't make money to dress-up their failures by reporting increased something to investors. When the traditional metric of profit couldn't be attained, they created a new one that made them appear successful.

In the accounting and business world, EBITDA is a firestorm of controversy. There are some who will defend it vehemently, and attempt to ridicule you for even suggesting it isn't worth the time it takes to pronounce the letters. Often, these people will appear to be very intelligent, driven, and professional. Don't worry about it - four hundred years ago, the brightest men on earth thought the world was flat. Smile and say a prayer of thanks because it's folly such as this that presents us with opportunity to profit in the market.

*$2,500 monthly pay - $625 taxes - $1,100 mortgage payment - $200 student loan payment = $525 free cash.

Next page > Income Taxes ... > Page <<back, 22, 23, 24, 25, 26, 27, 28, 29, more >> Income Before Tax

After deducting interest payments and, depending on the business, other expenses, you are left with the profit a company made before paying its income tax bill. This figure allows you to see what the business would have earned if it did not have to pay taxes to the government.

Income Tax Expense

The income tax expense is the total amount the company paid in taxes. This figure is frequently broken out by source (Federal, state, local, etc.) either on the income statement or somewhere in the annual report or 10K.

You should be fairly familiar with the tax laws affecting specific companies and / or business transactions. For instance, say the business you were analyzing just purchased $100 million worth of preferred stock that was paying a 9% yield (we'll talk more about preferred stock later). You could rightly assume the company would receive $9 million a year in dividends on the preferred. If the company had a tax rate of, say, 35%, you may assume that $3.15 million of these dividends are going to be paid to the Uncle Sam. In truth, corporations get an exemption on

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70% of the dividends they receive from preferred stock (individuals do not enjoy this luxury). Thus, only $2.7 million of the $9 million in dividends would be subject to taxation. Don't you love this stuff?

For your reference, here is a list of the corporate tax brackets. It would serve you well to memorize them:

Next page > Accounting for Minority Interest ... > Page <<back, 22 23, 24, 25, 26, 27, 28, 29, more >>

Corporate Tax Rate Reference Table

Corporate Income Tax Rates - 1998-2009 Taxable income over Not over Tax rate

$0 $50,000 15% $50,000 $75,000 25% $100,000 $335,000 39% $335,000 $10,000,000 34% $10,000,000 $15,000,000 35% $15,000,000 $18,333,333 38% $18,333,333 ... 35%

Minority Interests on the Income Statement

If Federated Department Stores, the owner of Macy's and Bloomingdale, purchased five percent of Saks Fifth Avenue, Inc., common sense tells us that Federated would be entitled to five percent of Saks' earnings. How would Federated report their share of Saks' earnings on their income statement? It depends on the percentage of the company's voting stock Federated owned. Cost Method (If Federated owned 20% or less)

The company would not be able to report its share of Saks' earnings, except for the dividends it received from the Saks stock. The asset value of the investment would be reported at the lower of cost or market value on the balance sheet. What does that mean?

If Federated purchased 10 million shares of Saks stock at $5 per share for a total cost of $50 million, it would record any dividends received from Saks on its income statement, and add $50 million to the balance sheet under investments. If Saks rose to $10 per share, the 10 million shares would be worth $100 million ($10 per share x 10 million shares = $100 million). The balance sheet would be adjusted to reflect $50 million in unrealized gains, less a deferred tax allowance for the taxes that would be owed if the shares were sold.

On the other hand, if the stock dropped to $2.50 per share, thus reducing the investments to $25 million, the balance sheet value would be written down to reflect the loss with a deferred tax

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asset established to reflect the deduction that would be available to the company if it were to take the loss by selling the shares.

The point is, the income statement would never show the five percent of Saks' annual profit that belonged to Federated. Only dividends paid on the Saks shares would be shown as dividend income (which is, actually, added to total revenue or sales in most cases). Unless you delved deep into the company's 10K, you may not even realize that the Saks dividend income is included in total revenue as if it were generated from sales at Federated's own stores. Equity Method (If Federated owned 21-49%)

In most cases, Federated would include a single-entry line on their income statement reporting their share of Saks' earnings. For example, if Saks earned $100 million and Federated owned 30 percent, they would include a line on the income statement for $30 million in income (30% of $100 million), even if these earnings were never paid out as dividends (meaning they never actually saw $30 million).

Consolidated Method (If Federated owned 50+%)

With the consolidated method, Federated would be required to include all of the revenues, expenses, tax liabilities, and profits of Saks on the income statement. It would then include an entry that deducted the percentage of the business it didn't own. If Federated owned 65% of Saks, it would report the entire $100 million in profit, and then include an entry labeled minority interest that deducted the $35 million (35%) of the profits it didn't own.

Next page > Unreported or Look Through Earnings ... > Page <<back, 22 23, 24, 25, 26, 27, 28, 29, more >>

The Importance of Unreported or Look Through Earnings

You'll notice that the cost method, which applies to holdings under 20%, only allows the company to report the cash it actually receives in the form of dividends as income. This can be misleading. If your company owned 15% of Microsoft, for the first 25+ years, you didn't see a dime in dividends, although your 15% share of the earnings was being reinvested in the business on your behalf by management and would have amounted to several billion dollars. Those earnings will subsequently lead to long-term rise in the value of your stock holding, and are therefore very important to your economic future.

Don't believe it? Say you inherit a business that your great-grandfather founded a century ago. At the end of every year, he used some of the business' profits to buy shares of Thomas Edison's company, General Electric. By the time the company came under your control in 2002, it owned 19% of GE's common stock (1,888,600,000 shares). General Electric paid a dividend that year of $0.72 per share. According to GAAP accounting rules, your business could only report the $1,359,792,000 in dividends you received.

However, the year before, General Electric had actually made a profit of $14.6 billion, of which, nineteen percent indirectly belonged to you. Although you could only report $1.36 billion in dividends, you actually have a legal ownership to $2.774 billion in the company's earnings ($1.36 billion were paid out to you as dividends, with the remaining $1.4 billion retained by GE for future expansion). This means that you were not allowed to report more than $1.4 billion in earnings that indirectly belonged to you.

The general logic states that because you never see that money, it shouldn't count as income. This is both misinformed and dangerous. The entire $2.774 billion belongs to you. The portion of

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the earnings that were not paid out will be reinvested into GE's business and subsequently result in a rise in the stock price. If someone were to value the business, they would include the entire $2.774 billion in their calculation because the entire amount was working to your economic benefit.

In Some Cases, A Huge Portion of a Company's Profits Won't Be Seen on the Income Statement Due to Accounting Rules

Famed investor Warren Buffett referred to these unreported profits as look-through earnings. The successful investor strives to put together a portfolio with the highest possible look-through earnings for each dollar invested. This will result in market-beating returns. In his 1980 Letter to Shareholders of Berkshire Hathaway, Buffett explained that Berkshire's income statement was reporting less than half of what the company's true economic earnings were due to the rules governing minority interests:

"Our holdings in this [20% or less] category of companies [has] increased dramatically in recent years as our insurance business has prospered and as securities markets have presented particularly attractive opportunities in the common stock area. The large increase in such holdings, plus the growth of earnings experienced by those partially-owned companies, has produced an unusual result; the part of 'our' earnings that these companies retained last year (the part not paid to us in dividends) exceeded the total reported annual operating earnings of Berkshire Hathaway. Thus, conventional accounting only allows less than half of our earnings "iceberg" to appear above the surface, in plain view."

The lesson is clear: You must add the non-reportable earnings of a company's partially owned businesses back into the income statement to come up with an accurate estimate of economic earnings.

Next page > Discontinued Operations ... > Page <<back, 22 23, 24, 25, 26, 27, 28, 29, more >> Continuing / Ongoing Operations vs. Discontinued Operations

In the 1990's, Viacom, owner of MTV, VH1, and Nickelodeon, purchased Paramount Studios. To pay for the acquisition, Viacom took on a large amount of debt. The company's Chairman, Sumner Redstone, began selling assets and businesses the company owned in order to help pay down this debt.

Simon & Schuster, a major book publisher, was one of the businesses Viacom decided to let go, ultimately selling it to British media group Pearson PLC for $4.6 billion dollars. How did the deal affect the company's revenue and earnings?

This is where discontinued and ongoing operations come to the rescue. As soon as Viacom sold Simon, it had a pile of cash from the buyer. However, it lost all of the revenue and profit the publisher generated. Viacom's management must somehow warn investors, "Hey, Simon

generated [X amount] of our profit and revenue. Since we no longer own the business, you can't plan on us earning this revenue / profit next year". To do that, the Viacom puts an entry on their income statement called "Discontinued Operations". This shows investors money that was earned from businesses that won't be part of the company's holdings for very much longer. Continuing operations are the businesses the company expects to be engaged in for the foreseeable future.

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Net Income from Continuing Operations

After all of these expenses are deducted, the investor is left with a figure called net income from continuing operations. This is a calculation of the profit generated by continuing operations during the period covered by the income statement.

Net Income from Discontinued Operations

The amount shown on the income statement under discontinued operations is the profit made during the period from the businesses that will not be a part of the company in the future. Next page > Be Highly Suspicious of Accounting Changes ... > Page <<back, 22 23, 24, 25, 26, 27, 28, 29, more >>

Accounting Changes

Generally Accepted Accounting Principles, or GAAP as they are often called, give management a lot of leeway in determining how to report earnings to shareholders. At times, a company may opt to change the way it has accounted for a particular item in the past, which may result in increasing or decreasing the reported profits despite the company actually being in the identical economic position.

Think back to our depreciation discussion. You saw that the same $5,000 computer could cause drastically different reported profit figures in each of the three years depending upon which method management chose. An aggressive manager could take over a company that had been using the sum of the years digits depreciation method and order the accountants to switch to the straight line depreciation method. With a waive of the pen, profits appear to go through the roof, especially if the business is asset intensive. In reality, you and the other shareholders aren't any richer. In fact, it's likely you are poorer because the manager probably got paid a bonus for his new, record breaking profits.

Management is required to disclose accounting changes in the 10K filings. It is tremendously important that you determine if the change was necessary or simply a maneuver to inflate the amount of profit reported to shareholders. If you suspect there are a lot of games going on with the accounting choices, just walk down the road. There are tens of thousands of companies in which you can buy stock, not to mention all of the small businesses you can acquire or start. It's not worth it to be in a partnership with dishonest people.

Next page > Preferred Stock Dividends on the Income Statement ... > Page <<back, 22 23, 24, 25, 26, 27, 28, 29, more >>

Net Income

By this time, you should run into the net income figure on the income statement. This is the total after-tax profit the business made for the period before required dividend payments on the company's preferred stock.

Why can't we just stop here? It has to do with the nature of preferred stock. Regular cash dividends on common stock are not deducted from the income statement. In other words, if a company made $10 million in profit and paid $9 million in dividends, the income statement would show $10 million, the balance sheet $1 million, and the cash flow statement $9 million in dividends distributed. Preferred stock dividends, on the other hand, are more like debt. That's why many companies include them on the income statement and then report another net income figure known as "net income applicable to common", which you'll learn about on the next page.

References

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An income statement is a financial statement that shows you the company's income and expenditures It also shows whether a company is making profit or loss for a given period The

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Under accrual basis accounting, Pizza Aroma would report rent expense and wages expense in September, even if the rent were paid in August and the wages were paid in October.. This

After extending all of the information to the operating activities portion of the work sheet we foot the columns and calculate a cash inflow of $100,000 and a cash outflow of

Rise to the related to statement calculates net profit margin to calculate absorption costing methods are the income and gas company would benefit from.. Here to make an

Contribution margin is, calculate gross profit margin from statement of goods sold from the company efficiency ratio as a percentage of performance ratio indicates how