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How to read and understand balance sheets and income statements?
Balance sheet:
The balance sheet presents a company’s financial position in a specified date, and it states the company’s assets, liabilities and the owner’s/stakeholders’ equity.
It allows to see what a company owns as well as what it owes to other parties as of the date indicated in the heading.
This information can interest banks, current investors, potential investors, company management, suppliers, some customers, competitors, government agencies, and labor unions.
For example, the banker who needs to determine whether or not a company qualifies for additional credit or loans will need it.
To understand the balance sheet:
- Know the Types of Assets
- Learn the Different Liabilities
- Know what is Shareholders’ Equity
- Analyse the balance sheet with ratios
Assets = Liabilities + Owner’s Equity
Owner’s equity and liabilities can be thought of as a source of the company’s assets. They can also be thought of as a claim against a company’s assets. For example, a company’s balance sheet reports assets of $100,000 and Accounts Payable of $40,000 and owner’s equity of $60,000. The source of the company’s assets are creditors/suppliers for $40,000 and the owners for $60,000. The creditors/suppliers have a claim against the company’s assets and the owner can claim what remains after the Accounts Payable have been paid.
Assets: things that the company owns.
Non-current assets:
– land, buildings, equipment, furniture, fixtures, delivery trucks, automobiles, etc.
-Intangible assets- Some examples of intangible assets include copyrights, patents, goodwill, trade names, trademarks, mail lists, etc.
*Trade names and trademarks that were developed by a company (as opposed to buying them from another company at a significant cost) may not appear on the balance sheet, even though they might be a company’s most valuable asset
Current assets:
Cash and other resources that are expected to turn to cash or to be used up within one year of the balance sheet date. (or one operating cycle.) Current assets are presented in the order of liquidity, i.e., cash, temporary investments, accounts receivable, inventory, supplies, prepaid insurance.
Liabilities: obligations of the company, for example
-Unearned revenues: a liability account that reports amounts received in advance of providing goods or services. When the goods or services are provided, this account balance is decreased and a revenue account is increased
– accounts payable: this current liability account will show the amount a company owes for items or services purchased on credit and for which there was not a promissory note. This account is often referred to as trade payables (as opposed to notes payable, interest payable, etc.)
Owner’s equity:
Shareholders’ equity is the initial amount of money invested into a business. If, at the end of the fiscal year, a company decides to reinvest its net earnings into the company (after taxes), these retained earnings will be transferred from the income statement onto the balance sheet and into the shareholder’s equity account. This account represents a company’s total net worth
Income statement
Basically, the income statement shows how much money the company generated (revenue), how much it spent (expenses) and the difference between the two (profit) over a certain time period (operating year).
The income statement is important because it shows the profitability of a company during the time interval specified in its heading.
Keep in mind that the income statement shows revenues, expenses, gains, and losses; it does not show cash receipts (money you receive) nor cash disbursements (money you pay out).
Net Sales: These terms refer to the value of a company’s sales of goods and services to its customers. Even though a company’s bottom line (its net income) gets most of the attention from investors, the top line is where the revenue or income process begins. Also, in the long run, profit margins on a company’s existing products tend to eventually reach a maximum that is difficult on which to improve. Thus, companies typically can grow no faster than their revenues.
Cost of Sales (cost of goods/products sold (COGS), and cost of services): For a manufacturer, cost of sales is the expense incurred for labor, raw materials, and manufacturing overhead used in the production of goods. While it may be stated separately, depreciation expense belongs in the cost of sales. For wholesalers and retailers, the cost of sales is essentially the purchase cost of merchandise used for resale. For service-related businesses, cost of sales represents the cost of services rendered or cost of revenues. (To learn more about sales, read Measuring Company Efficiency, Inventory Valuation For Investors: FIFO And LIFO and Great Expectations: Forecasting Sales Growth.)
Gross Profit (gross income or gross margin): A company’s gross profit does more than simply represent the difference between net sales and the cost of sales. Gross profit provides the resources to cover all of the company’s other expenses. Obviously, the greater and more stable a company’s gross margin, the greater potential there is for positive bottom line (net income) results.
Selling, General and Administrative Expenses: Often referred to as SG&A, this account comprises a company’s operational expenses. Financial analysts generally assume that management exercises a great deal of control over this expense category. The trend of SG&A expenses, as a percentage of sales, is watched closely to detect signs, both positive and negative, of managerial efficiency.
Operating Income: Deducting SG&A from a company’s gross profit produces operating income. This figure represents a company’s earnings from its normal operations before any so-called non-operating income and/or costs such as interest expense, taxes and special items. Income at the operating level, which is viewed as more reliable, is often used by financial analysts rather than net income as a measure of profitability.
Interest Expense: This item reflects the costs of a company’s borrowings. Sometimes companies record a net figure here for interest expense and interest income from invested funds.
Pretax Income: Another carefully watched indicator of profitability, earnings garnered before the income tax expense is an important bullet in the income statement. Numerous and diverse techniques are available to companies to avoid and/or minimize taxes that affect their reported income. Because these actions are not part of a company’s business operations, analysts may choose to use pretax income as a more accurate measure of corporate profitability.
Income Taxes: As stated, the income tax amount has not actually been paid—it is an estimate, or an account that has been created to cover what a company expects to pay.
Special Items or Extraordinary Expenses: A variety of events can occasion charges against income. They are commonly identified as restructuring charges, unusual or nonrecurring items and discontinued operations. These write-offs are supposed to be one-time events. Investors need to take these special items into account when making inter-annual profit comparisons because they can distort evaluations.
Net Income (net profit or net earnings): This is the bottom line, which is the most commonly used indicator of a company’s profitability. Of course, if expenses exceed income, this account caption will read as a net loss. After the payment of preferred dividends, if any, net income becomes part of a company’s equity position as retained earnings. Supplemental data is also presented for net income on the basis of shares outstanding (basic) and the potential conversion of stock options, warrants etc. (diluted). (To read more, see Evaluating Retained Earnings: What Gets Kept Counts and Everything You Need To Know About Earnings.)
References:
http://www.accountingcoach.com/balance-sheet/explanation/1
http://www.accountingcoach.com/income-statement/explanation/1
http://www.investopedia.com/articles/04/031004.asp
http://www.investopedia.com/articles/04/022504.asp
financial statements manipulations: http://www.investopedia.com/articles/fundamental-analysis/financial-statement-manipulation.asp
How to increase profitability using the information from the accounting statements?
There are a few ways to measure company’s profitability:
Profit margin analysis:
In the income statement, there are four levels of profit or profit margins – gross profit, operating profit, pretax profit and net profit. The term “margin” can apply to the absolute number for a given profit level and/or the number as a percentage of net sales/revenues.
The different calculations can help us understand the profitability in the different aspects of the company and know which part is less/more profitable.
Gross Profit Margin – A company’s cost of sales, or cost of goods sold, represents the expense related to labor, raw materials and manufacturing overhead involved in its production process. This expense is deducted from the company’s net sales/revenue, which results in a company’s first level of profit, or gross profit. The gross profit margin is used to analyze how efficiently a company is using its raw materials, labor and manufacturing-related fixed assets to generate profits. A higher margin percentage is a favorable profit indicator.
Industry characteristics of raw material costs, particularly as these relate to the stability or lack thereof, have a major effect on a company’s gross margin. Generally, management cannot exercise complete control over such costs. Companies without a production process (ex., retailers and service businesses) don’t have a cost of sales exactly. In these instances, the expense is recorded as a “cost of merchandise” and a “cost of services”, respectively. With this type of company, the gross profit margin does not carry the same weight as a producer-type company.
Operating Profit Margin – By subtracting selling, general and administrative (SG&A), or operating, expenses from a company’s gross profit number, we get operating income. Management has much more control over operating expenses than its cost of sales outlays. Thus, investors need to scrutinize the operating profit margin carefully. Positive and negative trends in this ratio are, for the most part, directly attributable to management decisions.
A company’s operating income figure is often the preferred metric (deemed to be more reliable) of investment analysts, versus its net income figure, for making inter-company comparisons and financial projections.
Pretax Profit Margin – Again many investment analysts prefer to use a pretax income number for reasons similar to those mentioned for operating income. In this case a company has access to a variety of tax-management techniques, which allow it to manipulate the timing and magnitude of its taxable income.
Net Profit Margin – Often referred to simply as a company’s profit margin, the so-called bottom line is the most often mentioned when discussing a company’s profitability. While undeniably an important number, investors can easily see from a complete profit margin analysis that there are several income and expense operating elements in an income statement that determine a net profit margin. It behooves investors to take a comprehensive look at a company’s profit margins on a systematic basis.
Return on assets analysis
This ratio indicates how profitable a company is relative to its total assets. The return on assets (ROA) ratio illustrates how well management is employing the company’s total assets to make a profit. The higher the return, the more efficient management is in utilizing its asset base
effective tax rate:
This ratio is a measurement of a company’s tax rate, which is calculated by comparing its income tax expense to its pretax income.
References:
http://www.free-management-ebooks.com/faqfi/performance-05.htm
http://www.investopedia.com/university/ratios/profitability-indicator/ratio1.asp
more-
http://www.graduatetutor.com/accounting-tutors/income-statements/
http://smallbusiness.chron.com/determines-companys-profitability-16116.html
http://www.dummies.com/business/accounting/understanding-profitability-ratios-in-bookkeeping/
http://www.investopedia.com/university/fundamentalanalysis/fundanalysis6.asp
http://www.investopedia.com/terms/r/ratioanalysis.asp
Product margin and product markup
The two concepts are telling different sides of the same story. The profit margin is addressing the profit as it relates to selling price. Markup addresses the profit as it relates to cost price.
Example
profit margin in these contexts is referring to gross profit margin for a specific sale, which is the profit earned on a product expressed as a percentage of total revenue from that product. For instance, if a company spent $1,000 for a good and received $3,000 in revenue, then gross profit margin is equal to ($3,000 – $1,000) / ($3,000), or 66.6%.
Markup is the retail price a product that is expressed as a percentage of wholesale costs; for instance, using the same numbers as the example above, markup would be equal to ($3,000 – $1,000) / ($1,000), or 200%.
Reference:
http://www.investopedia.com/ask/answers/102714/whats-difference-between-profit-margin-and-markup.asp
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