Income Statement
One of the most important things for a business to understand is its profitability—literally, its ability to make a profit from the products it creates or sells. There are two key factors in determining profitability: (1) how much revenue the sales of the products generate; and (2) how much it costs to make and deliver those products. The simplest way to think about the income statement is with the simple equation below:
Total Revenues - Total Expenses = Profit(or Loss)
In essence, subtract the amount everything cost the business from the amount of revenue (or income) the business earned to see the profit. If things cost the business more than it earned in revenue, the company will see a loss.
Of course, it’s not really that simple. There are different ways a business can make money, such as selling equipment. And there are also many expenses a business might incur during that same period of time. The income statement goes one step further, adding more detail so that people can understand where the key sources of income and expenses are.
To help us better understand this statement, let’s look at an example from SunsTruck. Note that when a number is negative, it appears in parentheses.
At the top of the statement, you’ll see that it clearly identifies three things: (1) the name of the company, (2) the title of the financial statement, and (3) the period of time the statement is summarizing. For this example, we’re looking at the income statement for SunsTruck for the Third Quarter (“Q3”), or the three months ending September 30, 2016.
The first category of numbers at the top is called revenues. This is the total amount of income that the company earned during this time period. You can see that there are two main sources of revenue, or income for SunsTruck: (1)
sales revenue
, which is the money the business earned from selling its main product, sunglasses; and (2)
other revenue
, which is the money the business made from other sources, such as selling old equipment. For this quarter, SunsTruck made $80,000, which is shown as
total revenues
.
The second area of revenue is related to the cost of earning that revenue. If you are in the service industry like a hospital or software design, this is called
cost of revenues
. In our example, SunsTruck sells a physical product, sunglasses, so it is called
cost of goods sold (COGS)
. This number represents the direct cost of either making the products or purchasing them from the supplier. In the case of SunsTruck, this number is the amount of money the company spent to buy the sunglasses from brands like Oakley or RayBan that were then sold in their truck. In the third quarter, SunsTruck spent $40,000 on sunglasses to sell in their truck.
The third area of revenue shows
gross profit
-—total revenue minus the cost of goods sold. The amount of gross profit that SunsTruck earned this quarter is $40,000. It is the total revenue minus the total COGS ($80,000 revenue - $40, ...
Income StatementOne of the most important things for a busin.docx
1. Income Statement
One of the most important things for a business to understand is
its profitability—literally, its ability to make a profit from the
products it creates or sells. There are two key factors in
determining profitability: (1) how much revenue the sales of the
products generate; and (2) how much it costs to make and
deliver those products. The simplest way to think about the
income statement is with the simple equation below:
Total Revenues - Total Expenses = Profit(or Loss)
In essence, subtract the amount everything cost the business
from the amount of revenue (or income) the business earned to
see the profit. If things cost the business more than it earned in
revenue, the company will see a loss.
Of course, it’s not really that simple. There are different ways a
business can make money, such as selling equipment. And there
are also many expenses a business might incur during that same
period of time. The income statement goes one step further,
adding more detail so that people can understand where the key
sources of income and expenses are.
To help us better understand this statement, let’s look at an
example from SunsTruck. Note that when a number is negative,
it appears in parentheses.
At the top of the statement, you’ll see that it clearly identifies
three things: (1) the name of the company, (2) the title of the
financial statement, and (3) the period of time the statement is
summarizing. For this example, we’re looking at the income
2. statement for SunsTruck for the Third Quarter (“Q3”), or the
three months ending September 30, 2016.
The first category of numbers at the top is called revenues. This
is the total amount of income that the company earned during
this time period. You can see that there are two main sources of
revenue, or income for SunsTruck: (1)
sales revenue
, which is the money the business earned from selling its main
product, sunglasses; and (2)
other revenue
, which is the money the business made from other sources,
such as selling old equipment. For this quarter, SunsTruck made
$80,000, which is shown as
total revenues
.
The second area of revenue is related to the cost of earning that
revenue. If you are in the service industry like a hospital or
software design, this is called
cost of revenues
. In our example, SunsTruck sells a physical product,
sunglasses, so it is called
cost of goods sold (COGS)
. This number represents the direct cost of either making the
products or purchasing them from the supplier. In the case of
SunsTruck, this number is the amount of money the company
spent to buy the sunglasses from brands like Oakley or RayBan
that were then sold in their truck. In the third quarter,
SunsTruck spent $40,000 on sunglasses to sell in their truck.
The third area of revenue shows
gross profit
3. -—total revenue minus the cost of goods sold. The amount of
gross profit that SunsTruck earned this quarter is $40,000. It is
the total revenue minus the total COGS ($80,000 revenue -
$40,000 COGS = $40,000 gross profit). Gross profit is a very
important number to know, because it is what’s left over to
cover all of the business’s other expenses. If gross profit is not
high enough, the company is losing money and (eventually) will
go out of business. In our SunsTruck example, the business has
$40,000 in gross profit to cover its remaining expenses.
Our second category on the income statement includes all of the
other types of expenses that a business has. You can see two
expense groupings: (1) selling, general and administrative
expenses and (2) marketing and advertising. Remember,
expenses are the costs it takes to keep a business going. Each
group includes a number of different but related costs.
Selling, general, and administrative expenses
often refer to costs associated with selling a product, such as
sales commissions and shipping costs, and/or administrative
needs such as rent or office supplies.
Marketing and advertising expenses
refers to the spend on promotional activities for the product.
While there are many other expense categories that businesses
use, these are two of the most common.
The next area of expenses is
income from operations
. In this line, all expenses are subtracted from the gross profit
($40,000 gross profit - $10,000 expenses = $30,000 income
from operations). This, too, is an important figure to watch
because it tells us whether or not a company’s core business is
profitable. For SunsTruck, its expenses were less than its gross
profit so there is a positive amount of income from its
operations of selling sunglasses.
4. The next area of expenses is
other expenses
. You’ll see
interest expense
under this category, which refers to the total amount of money
spent on interest for outstanding loans the company owes.
During the third quarter, SunsTruck had $500 in interest
expense on its outstanding loans.
Our third category is
pretax income
. In this line we subtract other expenses from the income from
operations to get our pretax income ($30,000 income from
operations - $500 other expenses = $29,500 pretax income). We
then need to account for the amount of taxes paid on this
income, which in our SunsTruck example was $7,000.
Our final category in the income statement is net income. Net
income shows how much money a business makes after all
expenses are paid. To calculate net income, we subtract the
income tax expense from the pretax income ($29,500 pretax
income - $7,000 income tax expense = $22,500 net income). In
the case of SunsTruck, net income is $22,500! It’s important to
know that net income can be positive (a profit) if revenues are
higher than the total of all expenses, or negative (a loss) if all
of the expenses are higher than revenues. But watch out! Net
income does not mean that you have this much in your checking
account. Remember, some revenues were done on credit and the
business has to wait to see its cash. Likewise, some expenses
have not yet been paid, only recorded.
5. WHEN TO USE THE INCOME STATEMENT
The income statement is useful when you want to understand
how profitable a business is. Generally speaking, a sign of a
successful and growing company is a steady increase in
revenue, with the difference between income and expenses
getting wider and wider. This indicates that the business is
making more money while controlling or even decreasing
expenses.
The Balance Sheet
It’s often helpful to have a quick summary of where things
stand, especially for your personal finances. Knowing what you
own compared to what you owe to other people gives you a
helpful snapshot of your current financial health. The balance
sheet, also known as the statement of financial position, is
unique because instead of looking at a business over a period of
time, it shows where the business stands at that moment.
The balance sheet gets its name from the fact that both sides of
the balance sheet have to be equal. There is a common equation
that summarizes the balance sheet:
Assets = Liabilities + Shareholders' Equity
If you think about it, this makes sense. If assets are the items a
business owns or controls, the business has to have the money
to pay for those things either by borrowing money (liabilities)
or getting money from investors or from retained earnings
(shareholder’s equity).
One thing to note about this statement is that individual
accounts are shown on the left and the summary accounts are
shown in the column on the right. Let’s look at a sample
balance sheet from SunsTruck:
6. The first category of the balance sheet is
assets
, which includes all of the things the business owns or controls.
You’ll notice there are two groups of assets: current and long-
term.
Current assets
are expected to be used up and replaced over and over during
the current twelve months.
Long-term assets
are items expected to last longer than one year. There can be
many types in both groups, but we’ll just focus on a few of the
most common ones.
In the current assets category, you have cash, accounts
receivable, and merchandise inventory.
Cash
is pretty simple—it’s the amount of money a business currently
has in the bank.
Accounts receivable
is the money that the business is owed from customers who
have already purchased products on credit.
Merchandise inventories
is the value of all of the merchandise products the company has
on hand but has not yet sold.
In the long-term assets category, you have SunsTruck’s
truck and equipment
, the total value of vehicles or other large equipment that the
7. business owns. Many businesses also have other long-term
assets like land, buildings, machinery, and patents.
Adding together a business’s current assets and long-term assets
gives us our
total assets
($32,000 total current assets + $68,000 long-term assets =
$100,000 total assets). As you can see, the total of all of
SunsTruck’s assets as of September 30, 2016 is $100,000.
The next section of the balance sheet is
liabilities
. This is the money that the business owes to other parties. Like
assets, liabilities are divided into current and long-term groups.
This lets everyone know what has to be paid over the upcoming
twelve months versus what’s not due for more than a year from
now.
In the current liabilities group, the first item is
accounts payable
. This is the total of all of the money the business owes for
things it has purchased on credit from suppliers related to the
creation of its products. For example, SunsTruck may purchase
all the sunglasses it expects to sell in the next month from a
sunglasses supplier with an agreement to pay the supplier back
in 30 or 60 days.
In the long-term liabilities group , you'll find loan categories:
Truck Loan
(the money SunsTruck owes for its mobile store) and
8. Operating Loan
(the money SunsTruck borrowed from a lender to provide cash
for expenses, such as meeting payroll).
Between current and long-term liabilities, the total of all the
money the business owes as of the given date is shown as
total liabilities
($10,000 current liabilities + $60,000 long-term liabilities =
$70,000 total liabilities).
Finally, in addition to loan liabilities, a business can get money
from investors. This money is shown in the
shareholders’ equity
section.
Contributed capital
shows the total amount of money given by outside investors.
Retained earnings
is the amount of profit that the business has kept to use to grow
the company instead of giving it back to the owners of the
business.
As of September 30, 2016, SunsTruck had
total shareholders’ equity
of $30,000.
Remember how we said both sides of the balance sheet have to
equal? To see that the SunsTruck balance sheet is “in balance”
at this moment of time, you can compare the total assets of the
business ($100,000) to the sum of total liabilities plus
shareholders’ equity ($70,000 total liabilities + $30,000 total
shareholders’ equity = $100,000 total liabilities and
shareholders’ equity), the last line of the balance sheet. As of
9. September 30, 2016, SunsTruck had $100,000 for both
“sides”—demonstrating that the balance sheet is balanced.
WHEN TO USE THE BALANCE SHEET
The balance sheet is useful to see how healthy a business is at
any particular time. It’s important to ensure that the business’s
debt, its liabilities, is a reasonable size relative to assets and
shareholders’ equity. If debt is growing, it may be a sign that
the business is not effectively converting its investments into
profits for the company’s owners.
Statement of Cash Flows
Many business leaders will tell you that the statement of cash
flows is the most important statement of them all—and that may
very well be true. In reality, if the business doesn’t have cash
on hand to purchase products or pay employees, it can’t keep its
doors open. Cash is the lifeblood of a business, and knowing
how much of it is available is vital for success.
As we’ve learned multiple times in this course, you can pick up
a lot about business from your personal life. Creating a
statement of cash flows is almost identical to balancing a
checkbook. You start off with a certain amount of cash and,
during a period of time, money comes in and money goes out.
Then, at the end of the time period, you have an ending cash
balance that is either higher, lower, or the same as the cash you
had when you started.
The statement of cash flows shows all of the cash entering and
leaving a company during a given period of time. It’s important
to know that cash is different from revenue! The revenue
number from the income statement includes both sales paid with
cash and sales made on credit. This second type of sale, where
10. the business has not yet received its cash, shows up indirectly
on the statement of cash flows as either an increase or decrease
in accounts receivable. A decrease in accounts receivable
indicates that more cash has been received than new sales made
on credit. An increase in accounts receivable indicates more
new sales were made on credit than cash received.
Let’s walk through a sample statement of cash flows for
SunsTruck. Note that when a number is negative, it appears in
parentheses.
The statement of cash flows focuses on three main types of cash
activities: (1) cash flows from operating activities, (2) cash
flows from investing activities, and (3) cash flows from
financing activities. Let’s look at each category in turn.
The first category,
cash flows from operating activities
, shows all the money coming in and going out from day-to-day
business operations. This includes sales, expenses, taxes paid,
employees’ salaries and more.
The next category is
cash flows from investing activities
, which includes money coming in and money going out that is
related to investments in things such as equipment or
manufacturing tools. Typically, there is cash going out to pay
for these investments. In this SunsTruck example, the business
only spent money to pay back their investment in the truck for
their mobile store.
Finally,
cash flows from financing activities
11. summarizes all of the money that is tied to activities like
borrowing and repaying money or getting funds from investors
by selling stock or issuing bonds. This will be a cash-coming-in
category if it shows new loans or investments increasing a
business’s bank account. Sometimes, however, this will be a
cash-going-out category if the business is repaying loans or
paying investors back by paying out stock dividends or interest
on bonds.
At the bottom of the statement of cash flows there are three key
numbers. The
net increase (or decrease) in cash
shows how much money was gained or lost in total during the
time period. The amount of cash at the beginning of the period
shows how much money was in the bank at the beginning of the
time period. Lastly, cash at the end of the period shows how
much money is in the bank at the end of the time period. This
figure ties back to the cash balance reported on the balance
sheet.
WHEN TO USE THE STATEMENT OF CASH FLOWS
The statement of the cash flows should be regularly checked and
updated to ensure that a business has the money on hand that it
needs to operate. It shows how effectively a business is using
its cash to grow the business and make it more profitable.
Financial statements are an essential part of knowing how well
a business is doing and how it can be improved. While there is a
lot to learn about these statements, like many things, they will
become easier to read and understand over time. By
familiarizing yourself with these statements and understanding
what they mean, you’ll be better able to support decision-
making within your company based on the information that
12. these accounting processes provide.
FINANCE & ACCOUNTING - SENIOR ACCOUNTANT
ANALYSIS
Due Date
Week 5
Note: While representative of possible situations faced by
SunsTruck Sunglasses, all scenarios in this assignment are
fictional.
Real Business
Large discount retailers like Target and Walmart employ large
teams of Finance and Accounting professionals to help measure
and understand the financial health of the business. Financial
and accounting information helps these businesses make
educated financial decisions, such as whether or not to continue
partnering with a retail supplier. While often smaller
businesses, it is equally important for these retail suppliers to
use financial and accounting data to make educated decisions,
such as the best approach to gaining additional funding.
Your Role
This week, you’ll assume the role of Senior Accountant with
SunsTruck Sunglasses.
Senior accountants take ownership of reporting costs,
profitability, margins and expenditures for a given business.
They use the principles of accounting to analyze sales
information, create financial reports, make recommendations
about the financial health of the company, and more. They are
13. also responsible for training junior accounting staff.
For the last six months, SunsTruck has partnered with the
discount retail store to run a pop-up sunglasses stand in their
stores for a big summer promotion. Due to the high customer
purchase rate, the store has requested stock for five additional
stores. SunsTruck needs to increase its capacity to meet the
additional demand. In order to do so, SunsTruck needs
additional money.
In this assignment, you will need to help determine which type
of financing option is best for your company and train your
junior accountants on the accounting cycle and financial
statements.
INSTRUCTIONS
Step 1: Financing
The junior accounting team has assembled a Financing Report
that (a) offers three options for securing the additional funds
required to meet the new order; and (b) details the criteria
Shaun, the owner of SunsTruck, would like you to consider
when choosing one of the three options. Based on this report:
Identify which financing option you think is the best option for
SunsTruck to pursue given Shaun’s constraints. Please explain
the rationale for your decision.
Note: You should complete Steps 2 & 3 after reading the
material in Week 5.
Step 2: Accounting Cycle
14. A junior accountant is working to get everything in order for the
new financing and has come to you with a question about what
do next in the accounting cycle.
Read the email the junior accountant sent you and identify the
best next step to take in the accounting cycle. Please explain
your reasoning.
Step 3: Financial Statements
A potential investor has been identified, but before it is willing
to commit, it has requested information about SunsTruck’s
current debt from the junior accountants.
Identify the correct financial statement for your junior
accountants that will provide the investor with the information
it has requested. Please explain to your junior accountants why
you are giving them this financial statement and where the debt
information is located.