The Income Statement

Income Statement Overview

The Hegemony Toy Company presents its results in two

statements by their nature, resulting in the following format,
beginning with the income statement

The income statement presents the financial results of a

business for a stated period of time. The income statement is an
essential part of the financial statements that an organization
releases. The other parts of the financial statements are the
balance sheet and statement of cash flows.

Hegemony Toy Company

Income Statement
For the years ended December 31

(000s)
Revenue
Other income
Changes in finished goods inventories
Raw materials used
Employee benefits expense
Depreciation and amortization expense
There is no required template in the accounting standards for
how the income statement is to be presented. Instead, common Impairment of property, plant, and
usage dictates several possible formats, which typically include equipment
Other expenses
some or all of the following line items:
Finance costs
Profit before tax
Income tax expense
Revenue
Profit for the year from continuing
operations
Tax expense
Loss for the year from discontinued
operations
PROFIT FOR THE YEAR
Post-tax profit or loss for discontinued operations and

The income statement may be presented by itself on a single

page, or it may be combined with other comprehensive income
information. In the latter case, the report format is called a
statement of comprehensive income.

for the disposal of these operations

(55,000)
(19,000)
276,000
(95,000)
181,000

(61,000)
(20,000)
99,000
(35,000)
64,000

(35,000)

$146,000

$64,000

$0.15
0.07
Hegemony Toy Company
Statement of Comprehensive Income

Other comprehensive income, subdivided into each

component thereof

(000s)
Profit for the year
Other comprehensive income:
Total comprehensive income
Exchange differences on translating foreign
operations
When presenting information in the income statement, the focus Available-for-sale financial assets
should be on providing information in a manner that maximizes Actuarial losses on defined benefit pension
plan
information relevance to the reader. This may mean that the
Other comprehensive income, net of
best presentation is one in which the format reveals expenses
tax
by their nature, as shown in the following example. This format TOTAL COMPREHENSIVE INCOME

typically works best for a smaller business.

Revenue
XXX
Expenses:
Change in finished goods inventories
XXX
Raw materials used
XXX
Employee benefits expense
XXX
Depreciation expense
XXX
Telephone expense
XXX
Other expenses
XXX
Total expenses
XXX
Profit before tax
XXX
However, relevance to the reader may dictate that a better
approach is to present expenses by function, in which case the
layout changes to something similar to the following example.
This format usually works best for a larger organization that has
multiple departments.
XXX
XXX
XXX
XXX
XXX
XXX
XXX
XXX
XXX

Of the presentation methods just described, showing expenses

by their nature is the simplest to account for, since it involves
no allocations of expenses between segments of the business.
However, showing expenses by their function makes it easier to
determine where costs are consumed within an organization,
and so contributes to the control of costs.
It is useful to include in either form of presentation however
many aggregated line items and subtotals are necessary to
most clearly convey to the reader the financial performance of
the reporting entity.
Detailed Income Statement Example

20x1
$800,000
15,000
(205,000)
(80,000)
(210,000)
(105,000)
(35,000)

Earnings per share:

Basic
Diluted

Profit or loss

Revenue
Cost of sales
Gross profit
Administrative expenses
Distribution expenses
Research and development expenses
Other expenses
Total expenses
Profit before tax

20x2
$1,000,000
10,000
(320,000)
(70,000)
(150,000)
(120,000)
0

$0.11
0.08

20x2
$146,000

20x1
$64,000

12,000

11,000

5,000
(1,000)

(2,000)
(5,000)

16,000

4,000

162,000

68,000

The cash flow statement shows how much cash comes in and
goes out of the company over the quarter or the year. At first
glance, that sounds a lot like the income statement in that it
records financial performance over a specified period. But there
is a big difference between the two.
Three Sections of the Cash Flow Statement
Companies produce and consume cash in different ways, so the
cash flow statement is divided into three sections: cash flows
from operations, financing and investing. Basically, the sections
on operations and financing show how the company gets its
cash, while the investing section shows how the company
spends its cash.
Cash Flows from Operating Activities
This section shows how much cash comes from sales of the
company's goods and services, less the amount of cash needed
to make and sell those goods and services. Investors tend to
prefer companies that produce a net positive cash flow from
operating activities. High growth companies, such as technology
firms, tend to show negative cash flow from operations in their
formative years. At the same time, changes in cash flow from
operations typically offer a preview of changes in net future
income. Normally it's a good sign when it goes up. Watch out for
a widening gap between a company's reported earnings and its
cash flow from operating activities. If net income is much higher
than cash flow, the company may be speeding or slowing its
booking of income or costs.
Cash Flows from Investing Activities
This section largely reflects the amount of cash the company
has spent on capital expenditures, such as new equipment or
anything else that needed to keep the business going. It also
includes acquisitions of other businesses and monetary
investments such as money market funds.
Cash Flow From Financing Activities
This section describes the goings-on of cash associated with
outside financing activities. Typical sources of cash inflow would
be cash raised by selling stock and bonds or by bank
borrowings. Likewise, paying back a bank loan would show up as
a use of cash flow, as would dividend payments and common
stock repurchases.

What is 'Financial Analysis'

Financial analysis is the process of evaluating businesses,
projects, budgets and other finance-related entities to determine
their performance and suitability. Typically, financial analysis is
used to analyze whether an entity is stable, solvent, liquid or
profitable enough to warrant a monetary investment. When
looking at a specific company, a financial analyst conducts
analysis by focusing on the income statement, balance
sheet and cash flow statement.
There are several general categories of ratios, each designed to
examine a different aspect of a company's performance. The
general groups of ratios are:
1.

Liquidity ratios. This is the most fundamentally

important set of ratios, because they measure the ability
of a company to remain in business. Click the following
links for a thorough review of each ratio.

Fixed asset turnover ratio. Measures a

company's ability to generate sales from a certain base
of fixed assets.

Inventory turnover ratio. Measures the amount

of inventory needed to support a given level of sales.

Sales to working capital ratio. Shows the amount

of working capital required to support a given amount of
sales.

Working capital turnover ratio. Measures a

company's ability to generate sales from a certain base
of working capital.

3.

Leverage ratios. These ratios reveal the extent to which

a company is relying upon debt to fund its operations,
and its ability to pay back the debt. Click the following
links for a thorough review of each ratio.

Debt to equity ratio. Shows the extent to which

management is willing to fund operations with debt,
rather than equity.

Debt service coverage ratio. Reveals the ability

of a company to pay its debt obligations.

Fixed charge coverage. Shows the ability of a

company to pay for its fixed costs.

4.

Profitability ratios. These ratios measure how well a

company performs in generating a profit. Click the
following links for a thorough review of each ratio.

Breakeven point. Reveals the sales level at

which a company breaks even.

Contribution margin ratio. Shows the profits left

after variable costs are subtracted from sales.

Gross profit ratio. Shows revenues minus the

cost of goods sold, as a proportion of sales.

Margin of safety. Calculates the amount by

which sales must drop before a company reaches its
breakeven point.

Net profit ratio. Calculates the amount of profit

after taxes and all expenses have been deducted from
net sales.

Return on equity. Shows company profit as a

percentage of equity.

Return on net assets. Shows company profits as

a percentage of fixed assets and working capital.

Return on operating assets. Shows company

profit as percentage of assets utilized.

Cash coverage ratio. Shows the amount of cash

available to pay interest.
Current ratio. Measures the amount of liquidity
available to pay for current liabilities.

Quick ratio. The same as the current ratio, but

does not include inventory.

Liquidity index. Measures the amount of time

required to convert assets into cash.

2.

Activity ratios. These ratios are a strong indicator of the

quality of management, since they reveal how well
management is utilizing company resources. Click the
following links for a thorough review of each ratio.

Accounts payable turnover ratio. Measures the

speed with which a company pays its suppliers.

Accounts receivable turnover ratio. Measures a

company's ability to collect accounts receivable.

Problems with Financial Statement Analysis

While financial statement analysis is an excellent tool, there are
several issues to be aware of that can interfere with your
interpretation of the analysis results. These issues are:
Comparability between periods. The company preparing
the financial statements may have changed the accounts in
which it stores financial information, so that results may differ
from period to period. For example, an expense may appear in
the cost of goods sold in one period, and in administrative
expenses in another period.
Comparability between companies. An analyst
frequently compares the financial ratios of different companies
in order to see how they match up against each other. However,
each company may aggregate financial information differently,
so that the results of their ratios are not really comparable. This

can lead an analyst to draw incorrect conclusions about the

results of a company in comparison to its competitors.
Operational information. Financial analysis only reviews
a company's financial information, not its operational
information, so you cannot see a variety of key indicators of
future performance, such as the size of the order backlog, or
changes in warranty claims. Thus, financial analysis only
presents part of the total picture.
Similar Terms
Horizontal analysis is also known as trend analysis.
Ratios and s in Customer Financial Analysis
Financial statement analysis is a judgmental process. One of the
primary objectives is identification of major changes in trends,
and relationships and the investigation of the reasons
underlying those changes. The judgment process can be
improved by experience and the use of analytical tools. Probably
the most widely used financial analysis technique is ratio
analysis, the analysis of relationships between two or more line
items on the financial statement. Financial ratios are usually
expressed in percentage or times. Generally, financial ratios are
calculated for the purpose of evaluating aspects of a company's
operations and fall into the following categories:

liquidity ratios measure a firm's ability to meet its

current obligations.

profitability ratios measure management's ability to

control expenses and to earn a return on the resources
committed to the business.

leverage ratios measure the degree of protection of

suppliers of long-term funds and can also aid in judging
a firm's ability to raise additional debt and its capacity
to pay its liabilities on time.

efficiency, activity or turnover ratios provide information

about management's ability to control expenses and to
earn a return on the resources committed to the
business.

A ratio can be computed from any pair of numbers. Given the

large quantity of variables included in financial statements, a
very long list of meaningful ratios can be derived. A standard list
of ratios or standard computation of them does not exist. The
following ratio presentation includes ratios that are most often
used when evaluating the credit worthiness of a customer. Ratio
analysis becomes a very personal or company driven procedure.
Analysts are drawn to and use the ones they are comfortable
with and understand.

Current Ratio
Provides an indication of the liquidity of the business by
comparing the amount of current assets to current liabilities. A
business's current assets generally consist of cash, marketable
securities, accounts receivable, and inventories. Current
liabilities include accounts payable, current maturities of longterm debt, accrued income taxes, and other accrued expenses
that are due within one year. In general, businesses prefer to
have at least one dollar of current assets for every dollar of
current liabilities. However, the normal current ratio fluctuates
from industry to industry. A current ratio significantly higher
than the industry average could indicate the existence of
redundant assets. Conversely, a current ratio significantly lower
than the industry average could indicate a lack of liquidity.
Current Assets
Current Liabilities
Cash Ratio
Indicates a conservative view of liquidity such as when a
company has pledged its receivables and its inventory, or the
analyst suspects severe liquidity problems with inventory and
receivables.
Cash Equivalents + Marketable Securities
Current Liabilities
Profitability Ratios
Net Profit Margin (Return on Sales)
A measure of net income dollars generated by each dollar of
sales.
Net Income *
Net Sales
* Refinements to the net income figure can make it more
accurate than this ratio computation. They could include
removal of equity earnings from investments, "other income"
and "other expense" items as well as minority share of earnings
and nonrecuring items.
Return on Assets
Measures the company's ability to utilize its assets to create
profits.
Net Income *
(Beginning + Ending Total Assets) / 2
Operating Income Margin
A measure of the operating income generated by each dollar of
sales.
Operating Income
Net Sales

Liquidity Ratios
Working Capital
Working capital compares current assets to current liabilities,
and serves as the liquid reserve available to satisfy
contingencies and uncertainties. A high working capital balance
is mandated if the entity is unable to borrow on short notice.
The ratio indicates the short-term solvency of a business and in
determining if a firm can pay its current liabilities when due.

Current Assets
- Current Liabilities

Acid Test or Quick Ratio

A measurement of the liquidity position of the business. The
quick ratio compares the cash plus cash equivalents and
accounts receivable to the current liabilities. The primary
difference between the current ratio and the quick ratio is the
quick ratio does not include inventory and prepaid expenses in
the calculation. Consequently, a business's quick ratio will be
lower than its current ratio. It is a stringent test of liquidity.

Cash + Marketable Securities + Accounts Receivable

Current Liabilities

Return on Investment
Measures the income earned on the invested capital.
Net Income *
Long-term Liabilities + Equity
Return on Equity
Measures the income earned on the shareholder's investment in
the business.
Net Income *
Equity
Du Pont Return on Assets
A combination of financial ratios in a series to evaluate
investment return. The benefit of the method is that it provides
an understanding of how the company generates its return.
Net Income *
Sales

Sales
Assets

Assets
Equity

Gross Profit Margin

Indicates the relationship between net sales revenue and the
cost of goods sold. This ratio should be compared with industry

data as it may indicate insufficient volume and excessive

purchasing or labor costs.
Gross Profit
Net Sales
Financial Leverage Ratio
Total Debts to Assets
Provides information about the company's ability to absorb
asset reductions arising from losses without jeopardizing the
interest of creditors.
Total Liabilities
Total Assets

Gross Receivables
Annual Net Sales / 365
Accounts Receivable Turnover
Indicates the liquidity of the company's receivables.
Net Sales
Average Gross Receivables
Accounts Receivable Turnover in Days
Indicates the liquidity of the company's receivables in days.
Average Gross Receivables
Annual Net Sales / 365

Capitalization Ratio
Indicates long-term debt usage.

Days' Sales in Inventory

Indicates the length of time that it will take to use up the
inventory through sales.

Long-Term Debt
Long-Term Debt + Owners' Equity

Ending Inventory
Cost of Goods Sold / 365

Debt to Equity
Indicates how well creditors are protected in case of the
company's insolvency.

Inventory Turnover
Indicates the liquidity of the inventory.

Total Debt
Total Equity
Interest Coverage Ratio (Times Interest Earned)
Indicates a company's capacity to meet interest payments. Uses
EBIT (Earnings Before Interest and Taxes)
EBIT
Interest Expense

Cost of Goods Sold

Average Inventory
Inventory Turnover in Days
Indicates the liquidity of the inventory in days.
Average Inventory
Cost of Goods Sold / 365

Long-term Debt to Net Working Capital

Provides insight into the ability to pay long term debt from
current assets after paying current liabilities.

Operating Cycle
Indicates the time between the acquisition of inventory and the
realization of cash from sales of inventory. For most companies
the operating cycle is less than one year, but in some industries
it is longer.

Long-term Debt
Current Assets - Current Liabilities

Accounts Receivable Turnover in Days

+ Inventory Turnover in Day

Efficiency Ratios

Days' Payables Outstanding

Indicates how the firm handles obligations of its suppliers.

Cash Turnover
Measures how effective a company is utilizing its cash.
Net Sales
Cash
Sales to Working Capital (Net Working Capital Turnover)
Indicates the turnover in working capital per year. A low ratio
indicates inefficiency, while a high level implies that the
company's working capital is working too hard.
Net Sales
Average Working Capital
Total Asset Turnover
Measures the activity of the assets and the ability of the
business to generate sales through the use of the assets
Net Sales
Average Total Assets
Fixed Asset Turnover
Measures the capacity utilization and the quality of fixed assets.
Net Sales
Net Fixed Assets
Days' Sales in Receivables
Indicates the average time in days, that receivables are
outstanding (DSO). It helps determine if a change in receivables
is due to a change in sales, or to another factor such as a
change in selling terms. An analyst might compare the days'
sales in receivables with the company's credit terms as an
indication of how efficiently the company manages its
receivables.

Ending Accounts Payable

Purchases / 365
Payables Turnover
Indicates the liquidity of the firm's payables.
Purchases
Average Accounts Payable
Payables Turnover in Days
Indicates the liquidity of the firm's payables in days.
Average Accounts Payable
Purchases / 365
Additional Ratios
Altman Z-Score
The Z-score model is a quantitative model developed in 1968 by
Edward Altman to predict bankruptcy (financial distress) of a
business, using a blend of the traditional financial ratios and a
statistical method known as multiple discriminant analysis.
The Z-score is known to be about 90% accurate in forecasting
business failure one year into the future and about 80%
accurate in forecasting it two years into the future.
Z = 1.2
x
+1.4 x
+0.6 x
+0.999 x
+3.3 x

(Working Capital / Total Assets)

(Retained Earnings / Total Assets)
(Market Value of Equity / Book Value of Debt)
(Sales / Total Assets)
(EBIT / Total Assets)

Z-score
less than 1.8
greater than 1.81 but less than 2.99
greater than 3.0

Probability of Failure
Very High
Not Sure
Unlikely

Bad-Debt to Accounts Receivable Ratio

Bad-debt to Accounts Receivable ratio measures expected
uncollectibility on credit sales. An increase in bad debts is a
negative sign, since it indicates greater realization risk in
accounts receivable and possible future write-offs.
Bad Debts
Accounts Receivable
Bad-Debt to Sales Ratio
Bad-debt ratios measure expected uncollectibility on credit
sales. An increase in bad debts is a negative sign, since it
indicates greater realization risk in accounts receivable and
possible future write-offs.
Bad Debts
Sales
Book Value per Common Share
Book value per common share is the net assets available to
common stockholders divided by the shares outstanding, where
net assets represent stockholders' equity less preferred stock.
Book value per share tells what each share is worth per the
books based on historical cost.
(Total Stockholders' Equity - Liquidation Value of Preferred
Stocks - Preferred Dividends in Arrears)
Common Shares Outstanding

otherwise, the entire amount is due in 30 days. The cost of not

taking the cash discount can be substantial
% Discount
360
x
100 - % Discount
Credit Period - Discount Period
Example
On a $1,000 invoice with terms of 2 /10 net 30, the customer
can either pay at the end of the 10 day discount period or wait
for the full 30 days and pay the full amount. By waiting the full
30 days, the customer effectively borrows the discounted
amount for 20 days.
$1,000 x (1 - .02) = $980
This gives the amount paid in interest as:
$1,000 - 980 = $20
This information can be used to compute the credit cost of
borrowing this money.
% Discount
100 - % Discount
= 2
98

360
Credit Period - Discount Period

x
x

360
=
20

.3673

As this example illustrates, the annual percentage cost of

offering a 2/10, net/30 trade discount is almost 37%.
Current-Liability Ratios
Current-liability ratios indicate the degree to which current debt
payments will be required within the year. Understanding a company's
liability is critical, since if it is unable to meet current debt, a liquidity
crisis looms. The following ratios are compared to industry norms.

Common Size Analysis

In vertical analysis of financial statements, an item is used as a
base value and all other accounts in the financial statement are
compared to this base value.

Current to Non-current

On the balance sheet, total assets equal 100% and each asset is
stated as a percentage of total assets. Similarly, total liabilities
and stockholder's equity are assigned 100%, with a given
liability or equity account stated as a percentage of total
liabilities and stockholder's equity.

Rule of 72
A rule of thumb method used to calculate the number of years it
takes to double an investment.

On the income statement, 100% is assigned to net sales, with all

revenue and expense accounts then related to it.
Cost of Credit
The cost of credit is the cost of not taking credit terms extended
for a business transaction. Credit terms usually express the
amount of the cash discount, the date of its expiration, and the
due date. A typical credit term is 2 / 10, net / 30. If payment is
made within 10 days, a 2 percent cash discount is allowed:

Current to Total =

Current Liabilities
Non-current Liabilities
Current Liabilities
Total Liabilities

72
Rate of Return
Example
Paul bought securities yielding an annual return of 9.25%. This
investment will double in less than eight years because,
72
9.25

= 7.78 years