Reading Financial Reports for Dummies (20 page)

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Returns:
Returns
are arrangements between the buyer and seller that allow the buyer to return goods for a number of reasons. I’m sure you’ve returned goods that you didn’t like, that didn’t fit, or that possibly didn’t even work. Returns are subtracted from a company’s revenue.

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Allowances:
Gift cards and other accounts that a customer pays for upfront without taking merchandise are types of
allowances.
Allowances are actually liabilities for a store because the customer hasn’t yet selected the merchandise and the sale isn’t complete. Revenues are collected upfront, but at some point in the future, merchandise will be taken off the shelves and additional cash won’t be received.

Most companies don’t show you the details of their discounts, returns, and allowances, but they do track them and adjust their revenue accordingly.

When you see a
net sales
or
net revenue
figure (the sales made by the company minus any adjustments) at the top of an income statement, the company has already adjusted the figure for these items.

Internally, managers see the details of these adjustments in the sales area of the income statement, so they can track trends for discounts, returns, and allowances. Tracking such trends is a very important aspect of the
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managerial process. If a manager notices that any of these line items show a dramatic increase, she should investigate the reason for the increase. For example, an increase in discounts could mean that the company has to consistently offer its products for less money, which could mean the market is softening and fewer customers are buying fewer products. A dramatic increase in returns could mean that the products the business is selling may have a defect that needs to be corrected.

Considering cost of goods sold

Like the sales line item, the cost of goods sold (what it costs to manufacture or purchase the goods being sold) line item also has many different pieces that make up its calculation on the income sheet. You don’t see the details for this line item unless you’re a company manager. Few firms report the details of their cost of goods sold to the general public.

Items that make up the cost of goods sold vary depending on whether a company manufactures the goods in-house or purchases them. If the company manufactures them in-house, you track the costs all the way from the point of raw materials and include the labor involved in building the product. If the company purchases its goods, it tracks the purchases of the goods as they’re made.

In fact, a manufacturing firm tracks several levels of inventory, including

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Raw materials:
The materials used for manufacturing

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Work-in-process inventory:
Products in the process of being constructed

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Finished-goods inventory:
Products ready for sale Sometimes tracking begins from the time the raw materials are purchased, with adjustments based on discounts, returns, or allowances given. Companies also add freight charges and any other costs involved directly in acquiring goods to be sold to the income statement’s cost of goods sold section.

When a company finally sells the product, it becomes a cost of goods sold line item. Managing costs during the production phase is critical for all manufacturing companies. Managers in this type of business receive regular reports that include the cost details. Trends that show dramatically increasing costs certainly must be investigated as quickly as possible because the company must consider a price change to maintain its profit margin.

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Even if a company is only a service company, it likely has costs for the services it provides. In this case, the line item may be called “cost of services sold” rather than “cost of goods sold.” You may even see a line item called

“cost of goods or services sold” if a company gets revenue from the sale of both goods and services.

Gauging gross profit

The gross profit line item in the income statement’s revenue section is simply a calculation of net revenue or net sales minus the cost of goods sold.

Basically, this number shows the difference between what a company pays for its inventory and the price at which it sells this inventory. This summary number tells you how much profit the company makes selling its products before deducting the expenses of its operation. If there’s no profit or not enough profit here, it’s not worth being in business.

Managers, investors, and other interested parties closely watch the trend of a company’s gross profit because it indicates the effectiveness of the company’s purchasing and pricing policies. Analysts frequently use this number not only to gauge how well a company manages its product costs internally but also to gauge how well the firm manages its product costs compared with other companies in the same business.

If profit is too low, a company can do one of two things: find a way to increase sales revenue or find a way to reduce the cost of the goods it’s selling.

To increase sales revenue, the company can raise or lower prices in order to increase the amount of money it’s bringing in. Raising the prices of its product brings in more revenue if the same number of items is sold, but it could bring in less revenue if the price hike turns away customers and fewer items are sold.

Lowering prices to bring in more revenue may sound strange to you, but if a company determines that a price is too high and is discouraging buyers, doing so may increase its volume of sales and, therefore, its gross margin. This scenario is especially true if the company has a lot of
fixed costs
(such as manufacturing facilities, equipment, and labor) that aren’t being used to full capacity.

The firm can use its manufacturing facilities more effectively and efficiently if it has the capability to produce more product without a significant increase in the
variable costs
(such as raw materials or other factors, like overtime).

A company can also consider using cost-control possibilities for manufacturing or purchasing if its gross profit is too low. The company may find a more efficient way to make the product, or it may negotiate a better contract for raw materials to reduce those costs. If the company purchases finished products for sale, it may be able to negotiate better contract terms to reduce its purchasing costs.

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Acknowledging Expenses

Expenses include the items a company must pay for to operate the business that aren’t directly related to the sale and production of specific products.

Expenses differ from the cost of goods sold, which can be directly traced to the actual sale of a product. Even when a company is making a sizable gross profit, if management doesn’t carefully watch the expenses, the gross profit can quickly turn into a net loss.

Expenses make up the second of the two main parts of the income statement; revenues make up the first part.

Advertising and promotion, administration, and research and development are all examples of expenses. Although many of these expenses impact the ability of a company to sell its products, they aren’t direct costs of the sales process for individual items. The following are details about the key items that fit into the expenses part of the income statement:

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Advertising and promotion:
For many companies, one of the largest expenses is advertising and promotion. Advertising includes TV and radio ads, print ads, and billboard ads. Promotions include product give-aways (hats, T-shirts, pens with the company logo on it, and so on) or name identification on a sports stadium. If a company helps promote a charitable event and has its name on T-shirts or billboards as part of the event, these expenses must be included in the advertising and promotion expense line item.

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Other selling administration expenses:
This category is a catchall for any selling expenses, including salespeople’s and sales managers’ salaries, commissions, bonuses, and other compensation expenses. The costs of sales offices and any expenses related to those offices also fall into this category.

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Other operating expenses:
If a company includes line-item detail in its financial reports, you usually find that detail in the notes to the financial statements. All operating expenses that aren’t directly connected to the sale of products fall into the category of other operating expenses, including

• General office needs:
Administrative salaries, expenses for administrative offices, supplies, machinery, and anything else needed to run the general operations of a company are reported in general office needs. Expenses for human resources, management, accounting, and security also fall into this category.

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Royalties:
Any
royalties
(payments made for the use of property) paid to individuals or other companies fall under this umbrella.

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copyrights owned by another company or individual. Companies also pay royalties when they buy the rights to extract natural resources from another person’s property.

• Research and product development:
Any costs for developing new products are listed in this line item. Most likely, you’ll find details about research and product development in the notes to the financial statements or in the managers’ discussion and analysis. Any company that makes new products has research and development costs because if it isn’t always looking for ways to improve its product or introduce new products, it’s at risk of losing out to a competitor.

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Interest expenses:
Expenses paid for interest on long- or short-term debt are shown in this line item. You usually find some explanation for the interest expenses in the notes to the financial statements.

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Interest income:
If a company receives interest income for any of its holdings, you’ll see it in this line item. This category includes notes or bonds held by the company, such as marketable securities, or interest paid by another company to which it loaned short-term cash.

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Depreciation and amortization expenses:
Depreciation on buildings, machinery, or other items, as well as amortization on intangible items, are shown in this line item. You have to look in the notes to the financial statements to discover more details about depreciation and amortization. To find out how these expenses are calculated, see Chapter 4.

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Insurance expenses:
In addition to insurance expenses for items such as theft, fire, and other losses, companies usually carry life insurance on their top executives and errors and omissions insurance for their top executives and board members.
Errors and omissions insurance
protects executives and board members from being sued personally for any errors or omissions related to their work for the company or as part of their responsibility on the company’s board.

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Taxes:
All corporations have to pay income taxes. In the taxes category, you find the amount the company actually paid in taxes. Many companies and their investors complain that corporate income is taxed twice — once directly as a corporation and a second time on the dividends that the shareholders receive. In reality, many corporations can use so many tax write-offs that their tax bill is zero or near zero.

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Other expenses:
Any expenses that don’t fit into one of the earlier line items in this list fall into this category. What goes into this category varies among companies, depending on what each company chooses to show on an individual line item and what it groups in other expenses.

However, a firm doesn’t include expenses relating to operating activities in this category; those expenses go on the line item for other operating expenses. Companies separate operating expenses from nonoperating expenses.

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Sorting Out the Profit and Loss Types

When you hear earnings or profits reports on the news, most of the time, the reporters are discussing the net profit, net income, or net loss. For readers of financial statements, that bottom-line number doesn’t tell the entire story of how a company is doing. Relying solely on the bottom-line number is like reading the last few pages of a novel and thinking that you understand the entire story. All you really know is the end, not how the characters got to that ending.

Because companies have so many different charges or expenses unique to their operations, different profit lines are used for different types of analysis.

I cover the types of analysis in Part III, but in this section, I review what each of these profit types includes or doesn’t include. For example, gross profit is the best number to use to analyze how well a company is managing its sales and the costs of producing those sales, but gross profit gives you no idea how well the company is managing the rest of its expenses. Using operating profits, which show you how much money was made after considering all costs and expenses for operating the company, you can analyze how efficiently the company is managing its operating activities, but you don’t get enough detail to analyze product costs.

EBITDA

A commonly used measure to compare companies is
earnings before interest, taxes, depreciation, and amortization,
also known as EBITDA. With this number, analysts and investors can compare profitability among companies or industries because it eliminates the effects of the companies’ activities to raise cash outside their operating activities, such as by selling stock or bonds. EBITDA also eliminates any accounting decisions that could impact the bottom line, such as the companies’ policies relating to depreciation methods.

Investors reading the financial report can use this line item to focus on the profitability of each company’s operations. If a company does include this line item, it will appear at the bottom of the expenses section but before line items listing interest, taxes, depreciation, and amortization.