Income Statements and Other Corporate Performance Measures
Ackerman, Ph.D., E.A.
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.
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?
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).
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.
company continually needs to borrow or obtain additional investor
capitalization to survive, the company's long-term existence is in jeopardy.
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.
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.
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.
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
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:
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.
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.
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.]
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.
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