with the financial statements and the language of business. The chapter begins the education process by creating a general expression for Net Income (NI), followed by a discussion of Earnings before Interest and Taxes (EBIT) and Earnings before Interest, Taxes and Depreciation (EBITDA).
Next the Balance Sheet is used to define Capital Employed (CE) and Return on Capital Employed (ROCE) and then to combine these expressions with the equation(s) developed for Net Income (NI). After a brief discussion of the kinds of Investments a company makes, the Cash Flow Statement is introduced to help define cash flow in terms of Cash Flow from Operating Activities (CFfOA), Cash Flow after Investing Activities (CFaIA), and Cash Generated/Used (CGU).2 Finally the Income Statement is worked backward, so to speak, where an expression is developed that describes the Required Revenue necessary to generate a given level of Net Income using the various components of the Income Statement.
⧉ Financial Statements
When one opens a financial report or a set of financial statements, the first statement encountered is usually the Income Statement, followed by a Balance Sheet and Cash Flow Statement. There isn't anything sacrosanct about this order of presentation. In fact they could be presented in any order. One of the reasons the presentation conventions have evolved in this manner is by doing so they present the financial affairs in a logical order. Stated simply, the Income Statement presents how a business has done during a period of time (usually the most recent period, i.e., month, quarter, or year). The Balance Sheet is a presentation of the Company's capital structure and ability to make investments. The Cash Flow Statement shows where the business generated cash and what it did with it and is developed from the accounts in the Income Statement and Balance Sheet. In the discussion that follows, the definitions implied by the simplified financial statements shown in Tables 1-1, 1-3, and 1-5 will be used.3
As its title implies, this chapter deals with basic concepts. The intent is to quickly move through the basic concepts associated with financial statements such as the Income Statement, Balance Sheet, and Cash Flow Statement and give the reader an overview. An in-depth discussion of this material and more will be provided in the chapters that follow.
⧉ The Income Statement
By inspecting Table 1-1, it's apparent that the Net Income (NI) can be expressed as
[1-1]Net Income = Revenue − Cost of Goods Sold − Operating Expenses
− Depreciation & Amortization + Interest Income
− Interest Expense − Taxes Paid4
or
[1-2]NI = Rev − COGS − OpExp − D & A ± NetInt − TaxesPaid
where:
± NetInt is a short form way of expressing “+ Interest Income – Interest Expense”
Table 1-1 Basic Income Statement
While Equation [1-2] is a solid definition of Net Income, it is often more useful to break it into its various constituents such as Earnings before Interest, Taxes, Depreciation and Amortization (EBITDA), Earnings before Interest and Taxes (EBIT), Earnings before Taxes (EBT), and Net Income (NI).
Again referring to Table 1-1, it should be clear that the Gross Margin (GM) can be defined in terms of the Revenues (Rev) and the Cost of Goods Sold (COGS).
Revenues represent the dollar amount the Company has charged its customers for its deliverable. The Cost of Goods Sold is the cost the company incurred producing the deliverable, and Gross Margin is what the Company has left over to cover Operating Expenses, Depreciation, Amortization, Interest, Taxes, and Profit.
[1-3]GM = Rev − COGS
In addition to the cost incurred to produce the deliverable, the Company also incurred costs such as Sales, Marketing, Research and Development, and Administration. These costs are known as Operating Expenses. The difference between the GM and OpExp is called Earnings before Interest, Taxes, and Depreciation and Amortization (EBITDA).
[1-4]EBITDA = GM − OpExp
Depreciation represents a charge to the Income Statement for Property, Plant and Equipment (PP&E) that has been purchased and is being expensed over its useful life. Amortization is similar except that it pertains to Intangible Assets the Company may have purchased such as patents, which, like PP&E, are expensed over their useful life. The difference between EBITDA and Depreciation and Amortization is the Earnings before Interest and Taxes (EBIT).5
[1-5]EBIT = EBITDA − D & A
Then allowing for the impact of Net Interest6 (NetInt) on Earnings before Interest and Taxes provides Earnings before Taxes (EBT).
[1-6]EBT = EBIT ± NetInt
Subtracting Taxes Paid7 (TaxesPaid) from the Earnings before Taxes yields the Company's Net Income (NI).
[1-7]NI = EBT − TaxesPaid
Since Taxes Paid are a function of the Earnings before Tax and the Tax Rate (TR), then
[1-8]TaxesPaid = (EBT)(TR)
Substituting in Equation [1-7],
[1-9]NI = EBT − (EBT)(TR)
Simplifying,
[1-10]NI = (EBT)(1 − TR)
NI can be expressed in terms of EBIT or EBITDA. Substituting the results of Equation [1-6] for EBT in Equation [1-10] gives an expression for NI in terms of EBIT.
[1-11]NI = (EBIT ± NetInt)(1 − TR)
To get an NI expression in terms of EBITDA it is necessary to once again refer to Table 1-1 and Equation [1-5] and then substitute for EBIT in Equation [1-11].
[1-5]EBIT = EBITDA − D & A
[1-12]NI = (EBITDA – D & A ± NetInt)(1 − TR)
Equation [1-12] says that for any given EBITDA, a company's Net Income is a function of the Depreciation and Amortization associated with investments made in prior periods, any interest paid or received and taxes.
This is not a book about taxes. So, other than
Other terminology used includes: CFF (cash flow from financing), CFI (cash flow from investing), and CFO (cash flow from operations).
There are two types of interest. Interest Income (interest earned on cash and investments) and Interest Expense (interest paid on debt). Net Interest can be either positive (interest income > interest expense) or negative (interest expense > interest income), hence the term ± NetInt.
Taxes Paid consist primarily of federal and state income taxes. Taxes such as municipal, wage, property, and so on are normally included in Cost of Goods Sold or Operating Expenses.
