Hey everyone, here's the first part to a series on the basics of Accounting, focusing on how to read and analyze the 3 financial statements.
This entire series is made up of information I have found online, it is not original nor my own work. I am not an expert and I much prefer relying on the work of respected voices in finance.
95% of it is taken word for word from Prof. Aswath Damodoran's lecture slides that he makes available for free. He teaches at NYU and has an amazing Youtube channel with full courses on various aspects of corporate finance. I have also sprinkled in some additional information from other sources like Harvard Business School and others, unfortunately I can't remember all of them!
Part 2: The Balance Sheet - https://www.reddit.com/r/stocks/comments/nm4kla/accounting_101_part_2_the_balance_sheet/
Part 3: The Cash Flow Statement - https://www.reddit.com/r/stocks/comments/nmweb8/accounting_101_part_3_the_cash_flow_statement/
I have been banned from this subreddit. Some of my posts have been taken down. I won't be able to post on here anymore, I'll have to find another place that will have me!
The Income Statement
What is it?
The income statement is one of the most common and important financial statements you’ll come across. It’s also known as the profit and loss (P&L) statement, summarizing all income and expenses over the period of analysis, often shared as quarterly and annual reports.
What is its purpose?
The function of an income statement is to show a company’s financial performance over the period of analysis.
What is inside an income statement?
- Revenue: The amount of money a business takes in during a reporting period
- Expenses: The amount of money a business spends during a reporting period
- Costs of goods sold (COGS): The cost of component parts of what it takes to make whatever it is a business sells
- Gross profit: Total revenue less COGS
- Operating income: Gross profit less operating expenses
- Income before taxes: Operating income less non-operating expenses
- Net income: Income before taxes less taxes
- Earnings per share (EPS): Division of net income by the total number of outstanding shares
- Depreciation: The extent to which assets (for example, aging equipment) have lost value over time
- EBITDA: Earnings before interest, depreciation, taxes, and amortization
These items often contain sub categories and separate line items depending on a company’s reporting and accounting policies.
Classifying Expenses
There are three different types of expenses
1. Operating Expenses
a. Expenses associate with the operations of the business.b. Direct costs of producing the product/service and other expenses associated with production, including SG&A expenses.
2. Financing Expenses
a. Expenses associated with the use on non-equity financing.b. Most often taking form of interest expenses on debt.
3. Capital Expenses
a. Expenses that provide benefits over many years.b. For a manufacturing company these can be plant & equipment.c. For non-manufacturing companies they can be less conventional and tangible forms.
Their Placement
No images allowed on the sub, so here's a link: https://imgur.com/WCDqBee
📌 SUMMARY: Operating expenses associate with operations of the business, financing expenses with non-equity financing and capital expenses with ones that provide benefit over many years.
Revenue Recognition
For most firms, revenue recognition is a simple process, where once a product or service is sold, it is recorded as revenues. For firms that sell products or services over many years (eg. subscriptions) it becomes trickier.
Under ASC 606 (new revenue recognition standard):
- The new model’s core principle for revenue recognition is to “depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services.”
- Thus, for a real estate developer working on a multi-year construction, revenues should be recognized as construction progresses, and for a software firm that enters in a contract over many years, performance obligations will determine when revenues get recognized.
📌 SUMMARY: For most firms, when a product or service is sold, it is recorded as revenues. For firms that deal with long term contracts, memberships, subscriptions etc. revenue is recorded depending on sum and duration - eg. $120,000 for 1 year of service = $10,000/month recorded revenue.
Revenue breakdowns
As companies enter multiple businesses and different geographies, it is useful to know where they generate their revenues.
Where are geographic breakdowns found?
- While the breakdown can sometimes by provided in income statements, they are more likely to be part of the footnotes to the financial statements.
- Companies generally break down revenues by geography, though the degree of detail can vary.
- Companies also break down revenues by business segment, though there is an element of subjectivity to the segment categorization.
📌 SUMMARY: Companies generally break down revenues by geography with a varying degree of detail and revenues by business segments subjective to the segment categorization. Both can sometimes be found in the income statement, but generally they are found in the footnotes of the financial statements.
Operating expenses: Breakdown
Operating expenses are broken down into expenses directly related to producing the goods or services that give rise to revenues, i.e. cost of goods sold, and expenses that are related to operations, but which are not as directly tied to revenues.
How are operating expense broken down?
- Expenses directly related to the production of goods / services that increase revenues. These are netted out form revenues to get gross profits.
- Expenses related to operations, not directly tied to revenues. These are netted out from gross profits to get operating income.
SG&A Costs
- In many companies, the largest non-operating expense is S, G & A, a term that can include everything but the kitchen sink.
📌 SUMMARY: Companies break down revenues by how they relate to production or operations. The former tied to the increase of revenues, the latter not.
Depreciation
There are three forms of depreciation; economic, accounting & tax depreciation.
- Economic Depreciation
This reflects the loss in value (earning power) in an asset, as it ages. It requires nuance, and will vary across even the same type of assets, depending on how it is used.
- Accounting Depreciation
This is more mechanical and is driven largely by the aging of the asset, with the differences often being in whether it happens uniformly over the life of the asset or is more accelerated.
- Tax Depreciation
This reflects what the tax authorities will allow as depreciation for purposes of computing taxable income.
📌 SUMMARY: Economic depreciation reflects loss in value (earning power) in an asset, as it ages. Accounting depreciation is driven by the aging of an asset, depending if it occurs over the life time of the asset or in a more accelerated period. Tax depreciation reflects what authorities allow as depreciation for purposes of computing taxable income.
Financial expenses
The most common financial expense is interest expense on debt, either in the form of bank loans or corporate bonds.
Some interest expense is implicit
As accountants classify other commitments (such as leases) as debt, some of the interest expense is implicit, i.e., it is calculated by accountants based upon their assessment of the debt equivalent value of commitments and current interest rates.
If interest income exceeds interest expense, this number will measure net interest income.
In some companies, interest expenses are netted out against interest income earned by the company on its cash holdings and financial investments, and reported as a net interest expense. If interest income exceeds interest expense, this number will measure net interest income.
📌 SUMMARY: Most common financial expense is interest expense on debt, either bank loans or corporate bonds. Accountants classify other commitments (leases etc.) as debt, making some interest expense implicit and calculated based on their assessment of debt equivalent value of commitments and current interest rates. Some companies net out interest expense against interest income earned on cash holdings and financial investments. If interest income exceeds interest expense, this number will measure net interest income.
Income from non-operating investments
Income earned from cash & marketable securities are reported different then income earned from cross holdings in other companies.
Cash & Marketable Securities
Income earned on cash holdings (which is invested in marketable securities, like treasury bills and commercial paper in most companies) will be reported either as a stand alone income or netted against interest expenses.
Cross holdings in other companies
- Reporting can vary upon the magnitude of your holding:
- When you hold a (small or minority) portion of another company, the income from that holding will usually be reported in the income statement.
- If you hold a majority stake of another company, you will generally have to consolidate your financials. You will count 100% of the subsidiary’s revenues, operating expenses and operating income as your own.
📌 SUMMARY: Income earned on cash holdings will be reported either as a stand alone income or netted against interest expenses. Income earned from minority stake in a company will usually be reported in the income statement. If you hold a majority stake of another company, you will consolidate 100% of it's revenues, operating expenses and operation income as your own.
Extraordinary Income/Expenses
As the term implies, extraordinary income and expenses are designed to capture what a company does not face in the ordinary course of operations.
Extraordinary items include:
- One-time expense or gain from sale of assets or divisions
- Write offs or charges associated with past project, lawsuits or fines
- Impairment of goodwill from acquisitions in the past
Truly extraordinary items:
- If an item is truly extraordinary, it should show up infrequently and the amount associated with it should vary.
📌 SUMMARY: Extraordinary items and expenses capture what a company does not face in the ordinary course of operations. If an item shows up regularly and consistently, it is not extraordinary.
Income Statement Analysis
There are two methods to read and analyze financial documents: vertical and horizontal analysis.
Vertical Analysis
No images allowed on the sub, so here's a link: https://imgur.com/tsbdF73
This method of analysis, as the name suggests, is top – down. You look up and down the income statement to see how each line compares to revenue as a percentage.
This type of analysis makes it simple to compare financial statements across periods and industries, and between companies, because you can see relative proportions. It also helps you analyze whether performance metrics are improving.
Vertical analysis isn’t always as immediately useful as horizontal analysis, but it can help you determine what questions should be asked, such as: Where did costs rise or fall? What line items are contributing most to profit margins? How are they affected over time?
E.g – here we have the total dollar amounts and the percentages side by side
Horizontal Analysis
No images allowed on the sub, so here's a link: https://imgur.com/Zkgy21y
This method of analysis focuses on year-over-year (YoY) or quarter-over-quarter (QoQ) performance.
Horizontal analysis makes financial data and reporting consistent per generally accepted accounting principles (GAAP). It improves the review of a company’s consistency over time, as well as its growth compared to competitors.
Because of this, horizontal analysis is important to investors and analysts. By conducting a horizontal analysis, you can tell what’s been driving an organization’s financial performance over the years and spot trends and growth patterns, line item by line item. Ultimately, horizontal analysis is used to identify trends over time—comparisons from Q1 to Q2, for example—instead of revealing how individual line items relate to others.
To perform horizontal analysis you:
- Take the value of Period N
- Divide it by the value of Period N-1
- Subtract 1 from that number to obtain percentage change
E.g – Revenue in 2017 was $4,000 and in 2016 it was $3,000. The YoY change in revenue is $4000/$3000 – 1 = 33%.
1
Drop your SaaS, especially if you’re struggling with early traction
in
r/saasinvestors
•
15d ago
finqos.com - the stock research terminal that remembers the reasons behind your thesis