This is the second in a series of articles intended to provide a working knowledge of financial statements, terms, and concepts, especially as that knowledge is useful in the practice of law. For business lawyers, the language of business is finance, and it pays to be equipped to understand the business dimension as well as the law.
The first article gave an explanation of the balance sheet. The present article seeks to explain how to best capture the information shown in the income statement.
At the broadest level, the income statement reports for a specific, discrete period of time (typically a year or a quarter) a company’s revenues, expenses, and earnings (i.e., profit or net income). This statement describes the company’s business model—how it makes money and (like the other financial documents) provides information about the performance and activities of the company. When you read a company’s income statement, consider the results in both an absolute and relative sense. How well does it appear to be doing, do things appear to be getting better or worse, and how does the company’s performance compare to that of its competitors? This information is particularly critical during unusual economic times (either good or bad). Management may actually be outperforming its competitors, despite what look like disappointing numbers.
Readers of the income statement are also looking for hints about the company’s future performance. Are the results you see likely to be indicative of future prospects, or are changes happening, good or bad? Are these changes likely to have a long-term impact or only a short-term one? Is the company gaining market share or losing it relative to its competition? Are there new entrants in fact or on the horizon? Is there disruptive technology that the company should be concerned with? For instance, might virtual meetings hurt airline ticket sales on a permanent basis? Further, does the company’s bargaining power appear to be getting better or worse, relative to its suppliers and customers? Answers to questions like these will help you get a feel for how the company is likely to do in the future, and the income statement contains information that can provide valuable insights into all of these areas. Don’t forget to read the MD&A (Management’s Discussion and Analysis). Not only does management explain much of the story behind the numbers, it also provides some level of prognostication about its view of the future.
Revenues—the Top Line
Revenue represents the value of the goods and/or services delivered to customers over the reporting period. Revenues constitute one of the most important lines of the income statement. A company can exist only to the extent that it is able to generate sufficient revenues to cover all of its costs and provide a return to its investors. What’s more, revenues often provide an important indication of a company’s relative strategic position.
A basic analysis of reported revenue looks at both the absolute amount and the rate of growth or decline over the last few periods. This leads to questions about the underlying drivers of revenue. Were the results an aberration, or were they indicative of the company’s current trajectory? To what extent are changes in revenue the result of price changes versus volume changes? Consider the context. In a period of crisis, such as COVID-19, revenues fell for many companies, but others have thrived. How did the company’s performance compare with that of its industry peers? What long-term industry shifts might be happening, and how are they likely to impact the company?
In our last article we discussed how the judgment inherent in the balance sheet has to do with the value of the line items. The critical judgement in the income statement is not value but timing. The income statement reports on activity over a specific period of time, based on the transactions that happened during the period. Judgment must be used when a transaction started in one period but was completed in a subsequent period; simply put, in which period should we report this transaction? At the risk of oversimplification, the Generally Accepted Accounting Principles (GAAP) rules are fairly straightforward; as long as the company either has been paid or has a reasonable belief that it will be paid, revenue is reported in the period in which the product or service was delivered. In some cases, this is easily determined; for a retail store, revenue is recognized when the customer pays for and takes the product. But in many cases, this is not a simple matter. For example, a technology firm may provide an integrated solution to its customer that takes three years to implement; clearly, how the total project is spread over the three years is a subjective matter.
About half of all securities fraud cases have traditionally involved revenue recognition. Yet, the fact patterns often make the rules difficult to apply and sometimes counterintuitive for the reader. It is always advisable to read the company’s footnote describing its revenue recognition policies (normally Footnote 1), as well as the company’s MD&A to get a complete picture of what the company’s revenue numbers should be telling us.
Expenses represent the value of the resources used to create the product or service provided to customers. If revenues are declining during an economic downturn, a key question is to what extent the company can cut its expenses correspondingly. To the extent that it can, it is more likely to survive the downturn. Of course, one ought to consider the longer-term effects of cost cutting. For instance, if skilled workers are laid off and business later picks up again, will they be available? What will be the future impact of a company reducing its research and development costs to survive a downturn? Consider also the competitive context. For instance, if the company is better able to weather the downturn than its competitors, then maybe it may gain competitively merely by surviving. Sidebar 1 explains the geography of a typical income statement.
Sidebar 1: The Geography of an Income Statement
The first expense line item is typically “cost of sales” or “cost of services.” This represents the direct cost to the company of making or procuring the goods or services that it sells. In the case of a retailer, that is pretty simple—the cost of buying the umbrellas, paper towels, or the like—and typically warehousing and transportation costs. In the case of a manufacturer, it includes all of the direct costs of making the goods (i.e., the direct labor and raw materials), as well as overhead costs like depreciation, utilities, insurance, benefits costs, supervision, and the like. Cost of sales is a much more difficult number to get exactly right for a manufacturer than for a retailer. The net of revenues minus cost of sales is the gross profit or gross margin. A higher gross profit suggests that the company has fairly strong pricing power.
Next comes the operating expenses—the costs of such activities as sales and marketing, research and development (or “R&D”), and administration (the CEO, COO, CFO, lawyers, etc.). Operating expenses includes all of the costs of running the company that are not directly involved in making or procuring the goods or services sold. Gross profit minus operating costs yields operating profit. This is a crucial number, as it tells us what the company earned from its operations. That is the amount that is available to the lenders, the taxing authorities, and the shareholders.
Operating profit is sometimes used interchangeably with EBIT, the earnings before interest and taxes. The operating profit divided by revenues is the operating margin, a key ratio. A high percentage indicates that the company is enjoying solid operations, though what constitutes excellent operating margins in one industry might be poor in another. For instance, what would be great operating margins in the grocery business would be poor for a real estate investment company—as witnessed by Kroger’s 3.2 percent operating margin in the quarter ending May 31, 2020, as contrasted with Boston Properties’ 30 percent operating margin in the second quarter of 2020. Net income is the amount of operating profit available to the shareholders after the allocations for taxes and interest. This can be measured by net margin, the net income as a percent of revenue,
We make a very important distinction between “costs” and “expenses.” Cost is the value of any resource acquired by the company. Inventory held for sale, the equipment to run a factory, and salaries to employees are all costs. Costs are shown in two places on the financial statements. “Capitalized” costs are shown as assets on the balance sheet. These are costs that will benefit the company in the future. “Expensed” costs are shown as expenses on the income statement, representing the resources used by the company during the reported period. The timing of “expense recognition” (when the costs are capitalized or expensed) is driven by something known in GAAP as the “matching principle.” Essentially, it says that expenses should be recognized on the income statement in the same period as the revenue that they helped generate. (Of course, the matching principle may be superseded in certain situations by specific accounting rules relating to a type of cost or expense.) All costs will become expenses sooner or later, though some may be expensed as they are incurred, while others may be capitalized through the balance sheet and appear on the income statement at a later date. An example of how this works is if a company buys a piece of equipment to manufacture the product that it sells. If that equipment has an expected useful life of five years, the company will show the cost of the equipment on its balance sheet and spread that cost over the five years that it realizes the benefit of the equipment as depreciation expense.
It can be useful to distinguish operating costs from financing costs. Operating costs are those related to the operations, such as making paint, operating a trucking company, writing software, or running a baseball franchise or law firm, whereas financing costs are those related to financing the business, such as lenders and shareholders that provided the funds to start or grow the company. Only operating costs are considered in calculating operating income.
With respect to operating costs, thinking in terms of “fixed” and “variable” costs can be useful. Variable costs are costs that are directly, inexorably related to the volume of goods produced or sold. Examples of variable costs include cost of materials and sales commissions; when volume increases, these costs automatically increase. Fixed costs are not directly related to volume. Examples include rent for the factory building. “Fixed” does not mean constant; fixed costs change regularly. But the changing fixed costs is a decision by the company, whereas variable costs change directly as a function of changes in volume. Sometimes it is very difficult to determine if a particular cost is fixed or variable; such costs are considered “semi-variable.”.
If a company is experiencing a severe downturn and is trying to survive, it is crucial to have an understanding of its fixed and variable costs. While its variable costs will decline along with revenues, its fixed costs will be unchanged, and high fixed costs are likely to cause the company to lose money in times of distress. On the other hand, it is also critical to understand which fixed costs require the immediate expenditure of cash, versus noncash expenses that either require no cash outlay (depreciation, for example) or will require a cash outlay only at some point in the future (such as deferred taxes and restructuring reserves). Because of these noncash expenses, not uncommonly companies experience significant operating losses during economic downturns, while at the same time generating positive cash flows from operations.
Sidebar 2: How the COVID-19 Downturn Impacted a High Fixed Cost Business (Delta Airlines)
It’s no secret that airlines are a classic example of companies for which fixed costs are a very high percentage of total costs, and the incremental cost of carrying the next passenger is usually quite low. Thus, when COVID-19 hit and air travel dropped dramatically, airlines had a very hard time managing costs.
In the second quarter of 2020, Delta Airlines’ revenues dropped 88 percent from the 2019 second quarter, resulting in an operating loss of $5.7 billion for the quarter versus an operating profit of $1.4 billion during the same period of the prior year. To protect itself, Delta cut back on the number of flights it offered, reducing its fuel costs by 84 percent and maintenance expenses by some 89 percent, instituted a hiring freeze, offered pilots early retirement, and reduced salaries by 50 percent and 25 percent for its officers and directors, and about half its workforce took a voluntary unpaid leave ranging from 30 days to 12 months. Yet despite cutting its operating expenses, 40 percent for the quarter, due to the high fixed costs Delta still had a loss for the quarter.
It is common to see large restructuring charges on the income statements of companies during periods of economic crisis. This occurs for two reasons. First, the company may decide to downsize and will set up a reserve for the actions it plans to take when it makes that decision, even though the downsizing may take several periods to enact. In addition, the current economic situation may have made the company reassess the value of assets on its balance sheet (including goodwill); to the extent that management feels that the value of any of these assets has been impaired, it will record an impairment charge as an expense. While both of these practices are not only proper but required under GAAP, sometimes management may tend to overstate these expenses during a downturn, with the idea of improving the appearance of its operations in future periods. Since these expenses tend to be noncash expenses, they will not impact cash flows from operations. The best way to understand the reasoning behind such charges is to read the notes to the financial statements and the MD&A.
The income statement tells us for a given period how much revenue a company generated, what expenses it incurred in doing so, and what earnings it netted. We can use it to understand a company’s business model and gain a sense of a company’s competitive position within its industry. For public companies, the MD&A provides a huge amount of useful information about revenues and expenses, as well as some indication of what we should expect for the future. The notes to the financial statements provide essential information about the key accounting policies and judgments used in generating the financials. These documents are especially critical during times of economic distress. As important as the income statement can be by itself, it takes on added importance when it is viewed in relation to the balance sheet, which shows the assets and capital the company required to generate its revenues and profit, and provides essential information about the sustainability of the company’s current operations.
Keep in mind that the income statement is an accrual document, not a cash document. For instance, revenues are booked when they are earned, and costs are often expensed when they are incurred regardless of when cash changes hands. To follow the cash, the key document is the cash flow statement, the subject of the next article in this series.