The Income Statement

The income statement for Clayton Homes is below.  The income statement might be given a slightly different name; however, the information it provides doesn’t change.  While the balance sheet shows the state of the company at some point in time, the income statement shows the change in revenues and expenses over a period of time.  For the case below, this period of time is one financial year (July 1, 1998 to June 30, 1999)
The document is a “consolidated statement of income,” in that the income statement from each business unit is taken and combined into one large income statement.

That’s the income statement!  Let’s go through some of the key points.

The Income Statement for Clayton Homes for Fiscal Year 1999

Revenues are flows into the company resulting from business activity.  For example, interest on cash in the bank isn’t considered as a revenue—a revenue comes from operations—what the company does.  If the company sold property and generated a lot of cash, that’s not revenue.  Sales and activities related to the operations of the company are revenues.  Sales are actually “net sales.”  Often, companies have a category called “allowance for doubtful accounts,” or something like that.  Not everyone pays their bills; there’s always a certain percentage of sales that are never collected, so companies estimate what that percentage might be.  Another account is created to manage this estimate—the allowance for doubtful accounts—a certain fraction of revenues would be placed in this account; the rest is a receivable.

You see the word “gain” in financial statements of companies.  A gain and revenue are not the same thing.  A revenue is a flow of assets into the company.  A gain, on the other hand, is an increase in the equity of the company.  We’ll talk about this topic when the statement of shareholders equity is reviewed.  A gain does not appear on income statement, it appears on the statement of shareholders equity.  For example, if Clayton Homes has made an investment in the shares of, say, Wal-Mart; these shares are recorded on the balance sheet as an asset.  If they’re sold at a profit, this profit is recorded as a gain in the equity of the company.  If they’re sold at a loss (that’s a challenge for a long term investor!), then the loss is recorded in the shareholders equity section.  Gains and losses occur in activities other than the core operation, the raison d’être, of the corporation.

We touched on revenue recognition before.  Different companies might have different rules.  For example, let’s stay you own an air conditioning installation company.  You might recognize a revenue when substantially all of the work is done.  Another company might wait until the house has been inspected by the city.  Different companies might have slightly different rules.

The next broad category is “costs and expenses.”  This category is actually operating expenses—expenses incurred in generating revenues.  Cost of sales might also be called the cost of goods sold.  For the example discussed earlier, the cost of goods is what was paid to buy the widgets.  Selling, general and administrative (called SG&A) lop pretty much all the other operational expenses into one neat bundle. You’ll find depreciation in here as well as the electricity bill and the cost of repairing the copy machine!  People often complain that their company doesn’t breakdown expenses into intimate detail.  But remember, if you can figure out the detailed cost structure, so can a competitor.  A company has to provide what is required and not too much more!  Clayton Homes has included some provisions for losses here too.  Companies might breakout an expense if they are “material.”  Material might mean greater than 5% of revenues—it depends upon the company.  The one expense that is sometimes broken out is research and development (R&D).  Clayton Homes has no material R&D expense.

Operating income is obtained by subtracting operating expenses (cost of sales, SG&A, financial services interest and provision for credit losses for the example of Clayton Homes) from revenues.  Revenues were $1.344 billion for the period and operating expenses totaled $1.092 billion.  The difference between these two numbers is $251.285 million.  Operating income is often referred to as earnings before interest and taxes, or EBIT (pronounced eee-bit!)

We’re not done with income just yet!  Clayton Homes also generated interest—this is recorded as interest income after the operating income.  If a company incurs a loss, the number would be placed in parentheses.  Operating income plus interest income is income before taxes.  A provision for taxes is added (estimated taxes) and this number is subtracted from income before taxes to give net income.  Net income is the very last line on the income statement (I’ll discuss what follows, but it’s really for information purposes), hence the phrase “what’s the bottom line”.

If there is any extraordinary income, it follows next.  Something is extraordinary if it’s not likely to occur again in the future.  Extraordinary items are often not generated from operations.  If a company found half a billion dollars of gold on land it owned, that would be extraordinary!

Net income is described on a per share basis as this information is useful to shareholders.  As we will see later, share price appreciation seems to correlate with earnings (net income), so knowing net income per share—earnings per share—is important.  Earnings per share is abbreviated as EPS—you will see EPS a lot!   EPS is obtained by dividing net income by the number of shares outstanding.  Note, if the company buys its own shares, those shares are not considered as outstanding, they are called treasury stock.  If a company buys back its own shares and “cancels” them, these shares are now neither issued nor outstanding.  (Suitable adjustments must be made to the statements of equity if shares are canceled.)  Only if the corporation owns and keeps these shares on the books are they referred to as treasury stock.

EPS is reported on a basic and diluted basis.  Remember EPS is found by dividing the net income by the number of shares outstanding.  So, why are there two flavors of EPS? It’s a good question.

I have alluded to this point early, when I talked about preferred shares.  Some financial instruments exist that can be converted into shares.  Some times preferred shares are convertible.  There are convertible debt instruments—convertible bonds.  Stock options exist.  A stock option is a financial instrument that gives the owner the right (but not the obligation) to buy shares of common stock at a predetermined price within a defined period of time.  To incentivize management, the board of directors might give the CEO options worth a half million shares.  The shares could be bought by the CEO at $5 per share any time within the next seven years.  The CEO gets to buy these shares regardless of the market price—the company will sell the shares (perhaps from the treasury stock) at $5 each.  Naturally, the CEO will only exercise the options if the shares are trading at more than $5 each.  Stock options have made some people extremely wealthy.

So, aside from the shares issued and outstanding, more shares could enter circulation if any of the financial instruments discussed above are converted or exercised.  If more shares come into existence, then the EPS will be diluted—same amount of net income divvied up among more shares.  Dilution is important to investors, since there is a relationship between share price and EPS.  Generally, if EPS grows, so will the share price.  If EPS falters—and if it’s diluted, EPS decreases—then the share price will probably decline too.  FASB, discussed earlier, has come up with some criteria for determining how to determine the effect of creating more shares.

FASB requires that EPS be reported on a basic and diluted basis.  To determine basic EPS, you take net income and divide it by the number of shares outstanding.  To calculate diluted EPS, companies have to follow the ruling promulgated by FASB (number 128).  They figure out what financial instruments could be exercised or converted into shares and then add these hypothetical shares to the number of outstanding shares.  If you look at the Clayton Homes example, they had, on average, 145,211,000 shares outstanding in fiscal year 1999.  Following FASB 128 there would have been, on average, 145,931,000 shares—three quarters of a million more!  Diluted EPS helps investors better understand the risks associated with EPS.  We will see later when we work with EPS in Parts II and beyond, we will only use diluted EPS.