ABC Building an Income Statement pt 10 Update 1 1 - YouTube

Welcome back to our intermediate Financial Accounting course. Over the last few segments

we've been talking about the income statement: what it is, why it's important, how to build a multi-step income statement, what other versions under

IFRS and US GAAP look

like, what adjustments we need to make for changes in estimate, changes in principle, discontinued operations, and extraordinary items.

We've talked about a statement of retained earnings, and how it fits in, and then we talked a little bit about comprehensive income.

Now it's time to wrap up this discussion of the income statement by talking about three of

the important ratios you can get out of that income statement.

We're gonna start by, perhaps, the most important number of all, and that is earnings per share.

Now, most investors consider earnings per share to be the most important number in accounting. Now,

that's a good thing, because it shows just how important our accrual accounting is for individuals.

I mean, all the adjusting entries that we make, all the

calculations that we do to create this income number have become super important to investors. So much so, that

analysts forecasts where earnings per share is going to be, companies will announce what they think it's going to be, and

there's a lot of focus on that number when it actually is presented, and how it looks compared to these earlier

guesses. The negative, is that companies are forgetting all of that other really important information

that we provide in the financial statements. The term here, from a psychology standpoint, is functional fixation.

Meaning, that we focus on earnings per share to the exclusion of all else. And,

while that's a good vindication, it

often worries us that they're forgetting, or avoiding, or simply not using this other information that we provide.

Because earnings per share is such an important number for most investors,

FASB has

insisted it has to be on an income statement for an income statement to be in good form.

So this means on any projects or examples that you do, you need to make sure this number is there. You need to have

two earnings per share numbers. And you can see I've actually listed three of them down here. Two of these are required,

one of them is recommended. You have to show income from continuing operations.

In other words you have to show the number

for the line. You also have to show the final net income earnings per share number.

You don't have to show income from discontinued operations for a couple of reasons: one, because you might not have any discontinued operations, but two

you don't really have to do it because it's going away. So because it's going away, FASB doesn't require it,

they simply recommend it. But you do have to record at least

income from continued operations, and net income, in order for your statement to be in good form. Now, for the examples that we're going to

do in our work, we're gonna focus just on that net income number.

But be aware you really should have both of them, and the calculation is just the same for all three options.

The only difference is, what income number we put into our equation. The basic equation

is this: net income, minus preferred stock dividends, divided by the weighted average common shares outstanding.

Preferred stock dividends, and I should add that in there.

It's preferred stock dividends, or the dividends paid to preferred stockholders.

Preferred stock is a passive stock that doesn't have any voting rights, what it has instead is preferential payment.

They get their dividends first, and in the case of liquidation, they get their money first.

So, because they don't really have voting rights, FASB doesn't consider them owners, and they don't really consider themselves owners.

They get a set dividend every year, they just get their dividend first.

So, because they're not really voting owners, then we take them out and we calculate earnings per share for the voting owners.

Calculating the weighted average shares outstanding is actually a lot of work.

It's a lot of fun, but it's a lot of work.

I actually have a memory of sitting in the testing center at Brigham Young University,

it's a vivid memory, of getting through about a page and a half of calculations, and

realizing that I had made a mistake on the second line, and

I had one of those eraser pencils, and I remember sitting there erasing a page and a half of calculations and

starting again so that I could get the right weighted average shares outstanding.

Now the good news for us right now, is we're not ready to get into anything that in-depth.

We'll leave that intermediate part 2, or advanced accounting. For now, we're going to keep it simple, but just be aware. There is a more

involved

version of this. We're just gonna use beginning

plus ending

divided by two, and we're going to use that as a

approximation of our weighted average shares outstanding.

The other thing we're not going to worry about right now, is diluted earnings per share. Diluted earnings per share

simply means, what if everybody who had the right to buy stock

bought it today? Then what would earning per share look like. We're gonna leave that for a more advanced class as well.

Let's take just a second and talk about earnings per share under IFRS. It's really pretty similar to US GAAP,

the only real difference, is that you don't have to show as many versions of earnings per share.

So you're still gonna show basic and diluted, you're going to show them for both total profit or net income and continue operations.

So what under US GAAP would call income from continuing operations?

But we don't have to do anything for discontinued, and we certainly don't have to do anything for extraordinary audits, because we don't allow

extraordinary items under IFRS. So that's earnings per share, and we'll do an example here in just a minute.

Next is our profit margin. Now, this is a very popular

profit ratio, or profitability ratio.

It's a measure of how much money a company actually makes for every $1 that they sell. How much of that dollar do we actually

keep? And so, the bigger it is, the better,

but competition typically keeps them relatively small, unless you're a monopoly, or you're in a brand new industry.

The basic equation, down here at the bottom of the screen,

you can see, we just take our net income number, and divide it by net sales.

So it's pretty straightforward as far as financial ratios go. The other ratio that we want to talk about,

that's just from the income statement, is times interest earned. Now,

this is a measure of liquidity. How well can we handle our debt and make the required payments?

It's a measure of how well we can handle our debt load, and

it's also a measure of whether or not we can make our interest payments as they come due.

So it's a risk ratio that we use to decide whether, maybe we have too much debt, or

we're locked into paying so much interest that we don't have other opportunities.

So that's really what we're looking at with times interest turned, and you can see, again, the equation down here at the bottom of

the screen. We're going to take income before taxes, and

interest expense, and divide

by interest expense. And the reason for taking income tax expense out of there is: if we paid all of that money in interest,

we wouldn't have to pay anything in taxes, because we'd get a tax break. Let's do an example

of our earnings per share, and our profit margin, and our times interest earned. Specifically, we're going to do these calculations

for CBDs, and we're going to start by adding earnings per share into the income statement.

So, let me go back to our income statement here. Now,

I should mention right here, earnings per share and that calculation is so important, that it's one of our key concepts for this topic.

Being able to calculate that number even the shortcut that we're going to learn is a key idea.

We don't have income from continuing operations, we don't have discontinued operations, and we don't have any extraordinary items on this basic statement.

If we were to do this earnings per share calculation for our other example,

we'd have to put all three of those in, but we don't have them on our basic example.

So we're just going to put in our earnings per share number.

And to do that, again, the equation is net income,

minus preferred stock dividends. Now CBDs has dividends, but if you look,

we're now back to their raw data page. You can see here, they have common stock,

but under the Ps, they don't have any preferred

stock. And since they don't have any preferred stock, I

don't have any preferred stock dividend. So I'm paying a dividend to the common stockholders. That's not preferred stock dividends,

so I'm gonna leave that out.

Next, I need my

weighted average shares outstanding, and remember, that's beginning, plus, ending divided by

two. And right here, we have

200,000 outstanding in year 2, and

200,000 outstanding in year 1,

so the average of those

would be 200,000. You take two hundred thousand, plus two hundred thousand, and divide by two, you get two hundred thousand.

So not a very exciting equation, but it'll work

for this first example.

So again, we're gonna take this 263,556, and we're gonna divide by two hundred

thousand, and that's our

earnings per share: a dollar thirty-two. And earnings per share always rounded to the nearest penny

by convention and that's earnings per share.

The other thing I need to mention right here, is another key concept. And that is, an income statement in good form. An

Income saving in good form, specifically a multi-step statement, always has a header with the name,

the title, and the date, just like you see here.

It's got two breakdowns for gross profit, for income from operations,

income from continued operations before taxes, and net income

has those other sections if it needs it. And then always, always, always, ends with earnings per share. So again, this basic format,

I believe we mentioned it before, is a key concept that we need to be comfortable with.

Let's do the other calculations. And we're gonna grab a couple numbers here. We want to do net income,

divided by net sales, and then we're going to do

income before taxes, and interest divided by interest expense. So let's go back to PowerPoint so we can write these out,

and show these equations. Let's start with our profit margin.

So profit margin,

again, is net income divided by net sales.

And in this case, our net income

is two hundred and sixty three thousand,

five hundred and fifty six dollars.

And our net sales are 1 million, eight hundred and five

thousand dollars. And if I divide those, I end up with net income

-Excuse me- I end up with a profit margin of

0.146. Let's go ahead and translate this into English. What this means, is for every one dollar of sales

CBDs brings in, they keep

14.6 cents. Is that good or bad?

Profit margin doesn't have a rule of thumb. It totally depends on the industry, and your place in the industry, and whether you're a

high-end seller, or a volume seller. It's going to be very different.

So, to really know, you gonna have to compare over time, and you have to compare with competitors and see how CBDs fits in.

Now, let's take a look at times interest earned.

Times interest earned, and again, that's income

before

taxes,

and interest

divided by

interest

expense.

So to get income before taxes and interest, the easiest way is to start with our income from

continued operations before

taxes cause that already takes care of this first

piece. So if I take income from continued operations before taxes, I have

351

408, and

then I'll add my interest expense into that. So

12,750 is interest expense, and then I'm going to divide

by the 12

750. This company actually has a really high value. It's twenty eight

point five

six one.

And again, I've rounded up to three decimal places. my translation here,

28.561, means that we could pay for our interest 28.561 times

with the profit that we made. Is that good or bad?

Well again, it's hard to tell. It depends on the industry, and the company's history, and how they're doing.

The investors might be really glad that you're not highly leveraged, but they might also be upset that you're not using

their money to get more money from banks and other lenders

to generate more profit for them. So it could go either way on this one.

It is a little high, but, again, it depends on the industry and the company policy.

We did remember to make a second income statement that we tweaked and changed. And I recommend that you go back and try doing these calculations

for that other

income statement. Obviously, I have to give you the numbers here. So I guess you could just go ahead and

jot them down, and not do the calculation, but I recommend pausing here, going and doing the calculations, and then when you come back,

then you can check and make sure your work is right. So please, pause it here and go do these ratios.

So here are our final values: we're going to end up with earnings per share from continuing operations of a $1.29,

earnings per share from discontinued operations of a negative

nineteen cents, and our final earnings per share on net income of $1.10. In

addition, we end up with a profit margin of

0.122.

So in other words, instead of keeping about fourteen cents for every dollar in revenue that we bring in,

because of the discontinued operation, it drops to about 12 cents for every dollar that we bring in in revenues. For

the times interest earned, the calculation is a little bit more, I won't say challenging, (let's call it fun!)

because there's more steps involved: we start with their net income: 220,731 dollars,

we then have to

subtract out the income tax benefit from the

discontinued operation, because we're getting rid of all taxes, in this case the benefit. So let's subtract out the 12,500.

We'll then add back in income tax expense,

the 86,077, that's the income tax expense on everything up to the line.

Then we'll add back in the 12,750 dollars, that's interest expense. And

finally, we will add all of those numbers up to get our numerator: 307,058 dollars.

And if we divide that by our interest expense, 12,750, we end up with times interest earned of

24.083. So a little bit more complicated, or

involved, or fun,

however, you want to say it. When we are doing discontinued operations because you can't just use that income from continuing operation shortcut.

Phew! That's a lot of information, isn't it?

We've talked about so much

with the income statement in its format, and why it's

important, and who uses it, and earnings per share, and how you calculate it and other ratios, what we added to the income statement,

how IFRS is different.

It's just a lot here, but it's so crucial that we have a good, solid understanding of this key

financial statement. It's used so much, both by accountants, by decision-makers, by regulators all

sorts of stakeholders

focus on this document, and we have to be comfortable with it, and the best way to be comfortable with it, is to be able

to build one, and I think

we're comfortable with that now. At least I hope we are. If not,

try about twenty or thirty of them,

and by the time you've done them all, you'll really feel comfortable with what they mean, and how they work. With that,

I will see you in our next segment, where we will start talking about the balance sheet.

See you then!