Understanding Financial Statements
Written by Bennet Grill for Gaebler Ventures
If you'd like to understand the significance and function of financial statements as it relates to running a business, then this article is for you. The third article in this four-part series on understanding financial statements focuses on Income Statements.
As an entrepreneur you started a business to make money.
As an entrepreneur you started a business to make money. The most fundamental evaluation of a business is achieved through an evaluation of its profits and its losses. The income statements (also known as P&L, representing profits and losses) does exactly this.
An income statement can be understood as a financial tool that starts out with revenue and deducts each expense individually until the net earnings, or profit, is calculated. The first item listed after revenue is usually the cost of goods. This number simply denotes the price of the materials used to create your product; usually this item is only included if your business sells a physical product. If so, the difference between the revenue (price paid by the consumers for your product) and the costs of goods (what you paid to make the product) is called gross margin. Costs of goods can be broken down and listed as each individual item used to produce the product. For example, a cabinet maker would list the cost of the wood, nails, bolts, and lining all under the heading "costs of goods." If your business provides a service instead of making a physical good, then the cost of goods can be excluded.
The next line item would be operating expenses. Operating expenses include everything from the rent of the building a company uses, to the salaries and benefits of the employees. Like costs of goods, operating expenses can be demarcated into individual line items such as salaries, travel, rent and insurance. Operating expenses cover everything spent to ensure the company is running and producing their product or service. Revenue minus costs of goods (if applicable) and operating expenses is known as operating earnings. This number describes the value of earnings before any financing activities, taxes or interest.
After you have your operating margin you calculate non-operating expenses. Common non-operating expenses include interest expenses on loans, depreciation, amortization and taxes. Depreciation is simply the reduction of the value of company assets due to time or use. Like a car, with each passing year and with additional use, assets of a company become less and less valuable. Amortization is the gradual payment of a balance over time. A company may decide to pay down a loan or credit facility in equal installments each month over 50 years. Companies usually include a line item called EBIT, which are earnings before interest expenses and taxes; this sometimes also includes a line item called EBITDA, or earnings before interest, taxes, depreciation and amortization. Both EBIT and EBITDA are used when evaluating a company and are an important financial metric to understand. After all non-operating expenses and taxes are accounted for, the net earnings or profit can be calculated. This number is closely related but not identical to FCF (free cash flow) found in the statement of cash flows.
The last major piece of information on an income statement is the EPS (earnings per share) value. To find this value, take the net earnings and divide it by the total number of shares issued to date. EPS is another financial metric often used in valuation purposes. More information about financial metrics and company valuation can be found in the fourth article in this series.
Understanding how to create and evaluate a company's income statement is an important part of running a successful business. Keeping track of a company's profits and losses can be easily done through the use of spreadsheet applications like Microsoft Excel and will greatly assist you in business operations. Make sure to read about balance sheets and cash flow statements on Gaebler.com, as they play an equally important role of measuring a company's performance.
Bennet Grill is a writer who has a passion for business and finance. He is currently an Economics major at Duke University in North Carolina.
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