2017 will be great!

Income Statements and Other Corporate Performance Measures

Roy A. Ackerman, Ph.D., E.A.

An income statement provides a breakdown of revenue and expenses.  How complete that is depends upon how deep one can delve into the numbers.  How clear it is depends if it based upon cash or accrual accounting- and how much information (regarding any subaccounts) is provided.  Basically, all income statements are not created equally.

The first thing you should check is the cash flow statement.  You have heard the statement that cash is king- this is its accounting. The cash flow statement details the sources of cash the company obtains and the outflows for a specific time period.  The cash flow statement provides the answer to the question:  Can the company pay its bills?

The big difference between cash flow and income statements is that non-cash items (such as depreciation) are not included in the cash flow analysis.  A company can be profitable (accounting standards) but be insolvent due to its inability to pay its bills.  The operating cash flow ratio (the ratio of cash generated to outstanding debt) provides an indication of the ability to service loans and interests.  By looking at the cash flow statement, one can determine the sensitivity of the data (a small drop in incoming cash could render the company to make loan payments; another company with much lower income but higher cash flow is in a better position).

The key reason to examine the cash flow statement is that there is not much manipulation possible.  Assuming no fraud, the cash flow statement tells the complete story- does the company have money or doesn’t it. If a company continually needs to borrow or obtain additional investor capitalization to survive, the company's long-term existence is in jeopardy.

There are only a few parts of the cash flow statement: Operations, Investing, Financing.  As you might expect, cash generation from daily business is found on the cash from operations portion.  Anything spent- or received in the course of the functioning of the firm belongs in this section.

Proceeds from the sale of assets (equipment, vehicles, portions of the business) and/or investments is found on the cash from investments portion.  Moneys used to acquire equipment is an investment- and it shows up here, too.  Any item that is a long-term asset needs to be accounted for on the cash from investment portion of the statement.

Any funds received from borrowings, paying back loans, or dividend payments if found under cash from financing sections.  Cash from financing includes money that comes about during startup (whether it comes from investors or is borrowed by the owners).  Any item that is classified as a long-term liability or equity is to be found here, as well.

These all combine to provide the net increase or decrease in cash (compared to last year or last period).

How to Determine Cash Flow from Operations:

There are two methods of producing this statement- neither method is wrong, but the Income Statement method is the preferred technique.  The Direct (or income statement) methodology starts with moneys received, subtracts moneys spend to derive net cash flow from operations.  (Remember, depreciation is not included here.  Yes, it is an expense that affects the profitability of the firm, but it does not describe any cash spent or received.)

The other method, the reconciliation (indirect) method, is a back-calculation process.  One starts with the net income, adds depreciation back to that number, and then addresses any changes in the balance sheet items.  One should arrive at exactly the same number as when computing the cash flow via the direct method.

How to Determine Cash Flow from Investing:

Any money spent on property, plan, and equipment is found here.  Obviously, if one is expanding operations, this could be a significant portion of cash flow usage.  If money is invested in the stock market or in the purchase/sale of other entities, these funds will be accounted for in this section.

How to Determine Cash Flow from Financing:

This portion addresses the payment of dividends, issuance of corporate stock, and borrowing or repayment of debt.  For small corporations, the last item is the most significant. 

When combined together, these sections provide the true cash flow statement for the firm. When a company is growing- or just starting up- there is substantial build-up of inventory (investment), collections from increasing sales (given the normal terms of thirty days and sales increases of more than 2% a month) mean that there is negative cash flow, in spite of positive net income.  Companies that are older or more established will have better matches between cash flow and income; if they don’t, there’s cause for analysis.

Some other areas of discrepancy between cash flow statements and income statements are when one chooses to use accrued income as the basis.  In a nutshell, cash based accounting recognizes income when it is in the company’s possession; expenses are recognized when the check is written. Accrual based accounting determines income when the item is shipped, the order is made or services occur; expenses are recognized when the goods or service has been received. [Notice there is no interactions between cash transactions and the recognition of transaction under the accrual basis.]

The question becomes whether one recognizes a sale at the time of the order or when it is delivered.  What happens if the service is delivered over months- is it recognized upon order, final delivery, or an agreed to schedule? What are the depreciation schedules- are things depreciated over 3 y, 10 y, or 30y?

Once you have done these analyses, you should then examine the performance over the past three to five years, using percentages of the total revenue, to determine trends.  One would hope that the growth in revenue exceeds that of expenses.  If not, there’s cause for alarm.

Another analysis necessary to determine performance is to examine gross profit [(revenue-cost of goods)/revenue](how well the company is doing), operating profit [(revenue-cost of goods-labor-administrative overhead)/revenue] (how well the company is operating), and net profit margins [net income/revenue] (how well the company prices its services/products or reacts to competition) over a few years.  This trend should be constant or increasing.

I would not term this the final analysis, but there are ratios to examine routinely for each business.  Some of these are the debt/equity ratio, inventory (total and turnover), payroll/revenue, overhead/revenue, and the quick ratio [(cash+accounts receivable)/accounts payable].