1
Q
It answers the question: “Did we make or lose money during a period of time?”
A
Income Statement
2
Q
All the money the company earned from its regular business (like selling products or services).
A
Revenue
3
Q
All the costs the company had to pay to make that revenue (like employee salaries, rent, marketing, and the cost of materials).
A
Expenses
4
Q
Basic Formula
A
Revenue (Money In) - Expenses (Money Out) = Net Income (The Profit!)
5
Q
Income Statement other names
A
- Statement of Operations
- Statement of Earnings
- Profit & Loss Statement
6
Q
A company can show P&L as its own standalone report, or it can be the first half of a bigger report called the…
A
Statement of Comprehensive Income.
7
Q
Reasons why Income Statement matters:
A
Growth: The stock market loves profit growth. A company whose profits are growing quickly will often have a higher stock price.
Valuation: The “profit” number (or “earnings”) is the most important ingredient analysts plug into their formulas to figure out what a stock should be worth.
8
Q
“Is this company making enough profit to safely pay its bills and its loan payments?”
A
Another way of looking at Income Statement
9
Q
The very first line (“Top Line”) on the P&L is almost always…
A
Revenue.
10
Q
This is the total amount of money a company earned from its regular business (selling goods or services).
A
Revenue
11
Q
Other names for Revenue
A
“Sales”, “Turnover”
12
Q
This is the total amount of money a company earned from its regular business (selling goods or services).
A
Revenue
13
Q
“Bottom Line” is also called
A
Net Income, Profit of the year, Net earnings
14
Q
Why it’s called the “Bottom Line”?
A
Because it’s literally at the bottom of the P&L, and it’s the final result of all the business activities.
15
Q
Bottom Line: On non-controlling interests
A
Accounting rules (called consolidation) say that if you own more than 50% of a company, you must report 100% of its revenue and 100% of its expenses, all mashed together with your own.
16
Q
Example for consolidation case
A
Let’s say AB InBev owns 80% of a smaller brewery. That brewery made $100M in profit.
• AB InBev has to add that entire $100M to its own P&L to get its “Net Income.”
• But… AB InBev doesn’t really get to keep all $100M. It only gets to keep its 80% share ($80M).
• The other 20% ($20M) belongs to the other 20% owners. This is the “noncontrolling interest.”
17
Q
Bottom Line headache
A
See what belongs to the parent and subsidiary companies
18
Q
Gains and losses vs. Revenue and expenses
A
Revenue & Expenses: Come from the company’s normal, ordinary business (making and selling beer).
Gains & Losses: Come from one-time, non-ordinary events. For example, if AB InBev sold a surplus factory, the profit (or loss) from that sale is a “Gain” or “Loss,” not “Revenue.”
19
Q
How are Expenses organized?
A
By nature and by function
20
Q
By Nature (What it is)
A
All similar types of costs are lumped together. You’d see lines like:
• Depreciation Expense (for all assets)
• Salary Expense (for all employees)
• Marketing Expense
21
Q
Gains and losses vs. Revenue and expenses
A
Revenue & Expenses: Come from the company’s normal, ordinary business (making and selling beer).
Gains & Losses: Come from one-time, non-ordinary events. For example, if AB InBev sold a surplus factory, the profit (or loss) from that sale is a “Gain” or “Loss,” not “Revenue.”
22
Q
By Function (Why you spent it)
A
Costs are grouped by the business purpose they served. You see lines like:
• Cost of Sales: Includes all costs to make the product (raw materials, factory worker salaries, factory depreciation).
• Selling & Marketing Expenses: Includes all costs to sell the product (sales team salaries, advertising, etc.).
• Administrative Expenses: Includes all costs to run the company (HQ rent, CEO’s salary).
23
Q
Income Statement Formats
A
- Single-Step
- Multi-Step
24
Q
Single-Step
A
It’s one simple calculation.
(All Revenues + All Gains) - (All Expenses + All Losses) = Net Income.
25
Multi-Step
This is much more common and useful. It shows key subtotals along the way that tell a better story.
26
Gross Profit Formula
Revenue - Cost of Sales = Gross Profit
27
What is Gross Profit?
This is the profit a company makes just from making and selling its product.
It ignores marketing, R&D, and corporate salaries.
It's a key measure of production efficiency.
28
Operating Profit Formula
Gross Profit - Operating Expenses = Operating Profit
29
What is Operating Profit?
This is the profit from the company's core, day-to-day business activities. It's a very important number because it ignores one-off gains/losses and, crucially, financing costs (like interest) and taxes.
30
Quick Note
You'll often hear "Operating Profit" called EBIT (Earnings Before Interest and Taxes).
The text warns that they aren't always exactly the same (some companies might have other weird items), but they are very similar.
31
For Service Companies (e.g., consulting)
Instead of "Cost of Goods Sold," they have "Cost of Services" (which is mostly their consultants' salaries).
32
On fiscal years
Some companies have weird fiscal years (e.g., 53 weeks instead of 52), which you have to watch out for when comparing year-over-year.
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When, exactly, does a company get to "count" its money as revenue?
Earned and cashed
34
Accrual Accounting
This principle states that:
Revenue is "counted" (recognized) when it is earned, not necessarily when the cash is received.
35
Earning before Cash (Example)
A graphic designer does a project for a client in February. The client doesn't pay the $1,000 invoice until April.
• The designer "counts" the $1,000 revenue in February, because that's when the work was done (i.e., "earned").
• When the cash arrives in April, it's not new revenue. It's just settling the bill (an "Account Receivable").
36
Cash before Earning (Example)
You pay $120 in January for a 12-month magazine subscription.
• Does the magazine "count" $120 in revenue in January? No. They haven't earned it yet.
• Instead, they have a liability (a promise to deliver 12 magazines).
• They "count" $10 of revenue each month ($120 / 12) as they mail you each magazine. This is called "unearned revenue."
37
The 5-Step Model for Counting Revenue
1. Identify the Contract(s) with a Customer
2. Identify the separate "Performance Obligations" (Promises)
3. Determine the "Transaction Price"
4. Allocate the Transaction Price to the Promises
5. Recognize Revenue when (or as) a Promise is Kept
38
Identify the Contract(s) with a Customer
Is this a real, legit deal? Is the customer probably going to pay us?
39
Identify the separate "Performance Obligations" (Promises)
What exactly did we promise to deliver? Is it one thing or multiple things? E.g., a phone + a 2-year service plan are two separate promises.
40
Determine the "Transaction Price”
How much money do we expect to get for all our promises?
41
Allocate the Transaction Price to the Promises
Let's say the phone + plan costs $1,000 total. How much of that $1,000 is for the phone and how much is for the service?
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Recognize Revenue when (or as) a Promise is Kept
We "count" the phone revenue when we hand over the phone. We "count" the service revenue month-by-month as we provide the service
43
Matching Principle
Record (or "recognize") your expenses in the **exact same period** that you record the revenue they helped create.
44
Doubtful Accounts (Customers Who Don't Pay): The Problem
The Problem: Let's say your company makes $1 million in sales on credit in January. You celebrate and record $1 million in revenue. But you know from experience that some of those customers will never pay you.
45
Doubtful Accounts (Customers Who Don’t Pay): The Wrong Way
The Wrong Way (The "Wait and See" Method): You wait until June, when you finally give up on a $10,000 unpaid bill. You'd record the $10,000 loss in June. **Accounting rules say this is wrong.**
46
Doubtful Accounts (The Right Application of “Matching Principle”)
The Right Way (The Matching Principle):
• The cost of making that $1 million in credit sales is the fact that some of it will go bad. You must "match" that cost to the January revenue.
• If you know from history that ~2% of your credit sales are never collected, you must record an estimated expense of $20,000 (2% of $1M) in JANUARY.
• This is called "Bad Debt Expense" or a "Provision for Doubtful Accounts."
47
Doubtful Accounts: The Bottom Line
The Bottom Line: You must record the expected loss from non-paying customers at the same time you make the sale, not months later when you confirm which customer defaulted.
48
Warranties (Products That Break): The Problem
The Problem: Your company sells 1,000 TVs in January. You record all that revenue. But you also gave a 1-year warranty. You know from experience that some of those TVs will break, and you'll have to pay to fix them.
49
Warranties (Products That Break): The Wrong Way
The Wrong Way (The "Wait and See" Method): You wait until a customer's TV breaks in August, and you record the $100 repair cost in August. Again, this is wrong.
50
Warranties (Products That Break): The Right Way (The Matching Principle)
The cost of selling those TVs includes the future promise to fix them. You must "match" that future cost to the January sale.
• If you know from history that 5% of TVs will need a $100 repair, you must record an estimated expense of $5,000 (1,000 TVs x 5% x $100) in JANUARY.
• This creates a **Warranty Liability** on your balance sheet, which is basically a pile of money you've set aside to pay for the future repairs you know are coming.
51
Warranties (Products That Break): The Bottom Line
The Bottom Line: The logic is identical. The Matching Principle forces you to estimate future costs (like bad debts or warranty repairs) and record them as an expense today, in the same period you made the sale.
52
Depreciation and Amortization: Big Idea of Spreading the Cost
Imagine you buy a $30,000 delivery van for your flower shop. You expect to use this van for 5 years.
53
Depreciation and Amortization: The Wrong Way
The Wrong Way: It would be misleading to report a giant $30,000 "van expense" in Year 1 and $0 "van expense" in Years 2, 3, 4, and 5. This would make Year 1 look like a disaster and the following years look artificially profitable.
54
Depreciation and Amortization: The Right Way (Matching Principle)
The Right Way (The "Matching Principle"): The van helps you make money (deliver flowers) for all 5 years. Therefore, you must "match" the van's cost to the revenue it helps generate. **The solution is to spread that $30,000 cost over its 5-year life.**
55
Depreciation
This is the term used for physical, tangible assets (like the van, a building, or a machine).
56
Amortization
This is the exact same concept but for intangible assets (things you can't touch, like a patent, a copyright, or a customer list).
57
Depreciation and Amortization: Key Exception
Key Exception: **You never depreciate land.** Why? Because land (theoretically) lasts forever and doesn't get "used up." The same goes for certain intangibles with "indefinite lives," like a powerful brand name (e.g., "Coca-Cola") or Goodwill.
(Goodwill is a weird accounting asset created when you buy another company for more than it's worth on paper).
58
The Two Big "Levers" Management Pulls
To "spread the cost," management must make two key estimates:
Useful Life and Residual Value
59
Useful Life
How long will we really use this asset? Is the van good for 5 years or 10 years?
60
Residual Value (or "Salvage Value")
What's this asset going to be worth when we're done with it? Can we sell the 5-year-old van for $5,000, or will it be $0 scrap?
61
How to Calculate the Expense: The 3 Main Methods
1. Straight-Line Method (Simple & Steady)
2. Accelerated Method (Front-Loaded)
3. Units of Production Method
62
Straight-Line Method (Simple & Steady)
This is the most common and easiest method. You just take the total cost to be expensed and spread it evenly.
• **Formula: (Cost - Residual Value) / Useful Life**
• Our Van Example:
($30,000 Cost - $5,000 Residual Value) / 5 Years = $5,000 per year
• The company will report a $5,000 depreciation expense every single year for 5 years.
The Analyst's "Aha!" Moment: Look what happens if management changes its estimates:
• Tweak the Life: "We think the van will last 10 years."
($30,000 - $5,000) / 10 Years = $2,500 per year
• Tweak the Value: "We think the residual value will be $10,000."
($30,000 - $10,000) / 5 Years = $4,000 per year
By making more "optimistic" estimates (longer life, higher residual value), management can decrease the annual expense, which directly increases the company's Net Income.
63
Accelerated Method (Front-Loaded)
This method assumes the asset is more useful and loses value faster in its early years. Think of a new car losing a huge chunk of value the second you drive it off the lot.
A common type is the **Double-Declining Balance** method.
• How it works (Simplified): It's a bit complex, but the idea is to take a percentage of the asset's remaining book value each year.
• Example (Van):
1. The straight-line rate is 1/5, or 20% per year.
2. "Double-declining" means you double that rate to 40%.
3. Year 1 Expense: 40% of $30,000 (full cost) = $12,000
4. Year 2 Expense: The van's value is now $18,000 ($30k - $12k).
40% of $18,000 (remaining value) = $7,200
5. Year 3 Expense: The van's value is now $10,800 ($18k - $7.2k)... and so on.
The Analyst's "Aha!" Moment: A company using this method reports a much higher expense in the early years ($12,000) and a much lower expense in the later years.
• This is seen as a "conservative" accounting choice because it lowers your profits today.
• When comparing two companies, if one uses straight-line and the other uses accelerated, their reported profits will not be comparable, even if their businesses are identical.
64
Units of Production Method
This method isn't based on time, but on **usage**.
• Concept: We'll expense the van based on the miles we drive.
• Example: We think the van will last 100,000 miles. We drove 15,000 miles in Year 1.
• Expense for Year 1 = (15,000 / 100,000) * ($30,000 - $5,000) = $3,750
65
A Final Note: IFRS vs. US GAAP
• Revaluation: IFRS (global rules) allows companies to "revalue" their property and equipment to its fair market value each year. US GAAP forbids this. In practice, almost no one uses this revaluation model anyway, so it's not a major difference.
• Components: IFRS is more precise, requiring companies to depreciate a component separately (e.g., depreciate a plane's engine over 10 years and its seats over 5 years). US GAAP is more relaxed.
66
The Big Takeaway
Depreciation and amortization are "non-cash" expenses (no money leaves the bank), but they are real costs.
The method (straight-line vs. accelerated) and the estimates (useful life vs. residual value) are management choices that can significantly change a company's reported Net Income. An analyst must read the footnotes to understand these choices before comparing two companies.
67
The Big Idea: The "Main Job" vs. "Side Hustles"
Think of a company's Income Statement as being split into two sections:
1. Operating Income: This is the profit from the company's main, day-to-day business. If you're a brewery, this is all the profit from making and selling beer.
2. Non-Operating Income: This is profit (or loss) from "side hustles" and "personal bills" that aren't part of the core business.
Analysts must separate these two. You want to know if the company is good at its "main job" (operating), not just getting by on lucky "side hustles" (non-operating).
68
For a "Normal" Company (like a Brewery or a Car Maker)
• OPERATING = Revenue from sales, cost of goods, marketing, R&D, salaries.
• NON-OPERATING = This is mostly investing and financing stuff.
69
Non-operating
**Interest/Dividend Income:** You're a brewery, but you have $1 million in extra cash. You park it in some Apple stock and get a dividend. That's a "side hustle." It's non-operating income.
**Interest Expense:** You're a brewery and you took out a $50 million loan to build a new factory. The interest you pay on that loan is like a "personal bill." It's a financing cost, not a beer-making cost. It's a non-operating expense.
**Profit from selling securities:** You sell that Apple stock for a gain. That's also a non-operating gain.
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The Big Exception: A Bank
For a bank (a "financial service company"), what's the "main job"?
**Lending and borrowing money.**
Therefore, for a bank, Interest Income and Interest Expense are absolutely OPERATING items. It's their "core business."
71
The Big "Trap": P&L Rules ≠ Cash Flow Statement Rules
The way we classify "interest" on the Income Statement (P&L) is **DIFFERENT** from how we classify it on the **Statement of Cash Flows (SCF).**
• **On the P&L (US GAAP):** For a non-financial company, interest income/expense is Non-Operating.
• **On the SCF (US GAAP):** Interest income received and interest expense paid are both classified as Operating cash flows (CFO).
**Your Takeaway:** Don't try to make the P&L rules and the SCF rules match. They are two different sets of rules. Just memorize them separately.
72
Why Care?
You analyze the two sections for completely different reasons:
1. You look at **Operating Income** to see how healthy the core business is and to forecast future sales and margins.
2. You look at **Non-Operating Items** to understand the company's financial policies.
• Interest Expense: Tells you how much debt the company uses. (High debt = high-interest expense).
• Investing Income: Tells you what the company is doing with its extra cash.
Point: If you're analyzing a brewery and you suddenly see a ton of investing income, you must ask WHY?
• Are they just smartly investing their extra cash in safe bonds? (Normal.)
• Or are they acting like a venture capital firm, making risky strategic bets on other companies? (This is a totally different risk profile you must investigate.)
73
A Simple Guide to Common-Size Income Statements
This is a very common and powerful tool for analysts. The big idea is to stop looking at raw dollar amounts (which are confusing) and **start looking at percentages** (which tell a story).
74
The Big Idea: "Where does every dollar of sales go?"
A common-size income statement takes every single line on a P&L and expresses it as a percentage of total revenue.
**Revenue (or Sales) is always set to 100%.**
Then, every other line item becomes a percentage of that 100%.
For example, if:
• Revenue = $1,000,000 (100%)
• Cost of Sales = $400,000 (40%)
• Operating Profit = $200,000 (20%)
75
Why Do This? (The Two Main Reasons)
1. Comparing a Company to Itself (Time-Series)
2. Comparing to Other Companies (Cross-Sectional)
76
Comparing a Company to Itself (Time-Series)
You can spot trends. Let's say your company's "Cost of Sales" was 40% last year but is 45% this year. Even if your revenue grew, your efficiency got worse. You're spending 5 extra cents to make every dollar of sales. Why?
FSA
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