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 going on record stating that management should employ the best professionals they can afford to help them minimize taxes there will be little more said on the subject.
Interest is of course a consequence of cash on hand or debt, which is a component of the company's capital structure (how the business is financed by the owners). Debt and its implications will be revisited when leverage is discussed in Chapter 9.
Depreciation and Amortization, as stated earlier, is a period expense that results from depreciating or amortizing assets over their useful life. Once money is spent on an investment, the investment is capitalized on the company's balance sheet and then written off by periodic charges to the D&A account on the Balance Sheet via the Income Statement over the asset's useful life. Successful management teams consistently make investments that provide a recurring contribution to income greater than the associated periodic D & A.8
Special Case: Ignoring the Interest Component
While debt and associated costs must be thoughtfully managed, when it comes to creating value, management's prime responsibility is to focus on what happens to the money invested in the business. In fact well-managed private and public companies don't want their management teams spending a lot of time on financial engineering. As far as management is concerned capital structure need only be addressed periodically when the company needs funds to finance such things as a major acquisition. Investors want their team to concentrate on creating value, which is done by growing the top and bottom lines of the Income Statement. When it's appropriate to ignore the “Interest” component, then Equations [1-11] and [1-12] become Equations [1-13] and [1-14] respectively.9
[1-13]NI = (EBIT)(1 − TR)
[1-14]NI = (EBITDA − D & A)(1 − TR)
Example 1-1: Calculating Net Income
Using the data in Table 1-1 and Equations [1-2], [1-11], and [1-12] show that the Net Income in each case is $6,900,000.
Applying Equation [1-2] and substituting values for each of the terms from