Introduction to the income statement | Stocks and bonds | Finance & Capital Markets | Khan Academy

I figure now is as good a time
as any to learn about probably what most people focus the
most on when they analyze companies, and that's the
income statement. And the income statement is
one of the three financial statements that you'll look at
when you look at a company. There's the income statement
and the other two are the balance sheet, which I have
drawn a lot in a lot of the other explanations I've done
on the financial crisis and whatever else. And actually, in this video,
we're going to see how the income statement relates
to the balance sheet. And, of course, the last one–
well, it's not of course if you don't know it– is the
cash flow statement. And we'll focus on that a
little bit later because that's a little bit more
nuanced relative to the income statement. So the income statement is
literally just saying how much a company might earn in a given
period, and it's always related to a period.

So it could be an annual
income statement. It could be for the year 2008. It could be a quarterly
income statement. Those are usually the two
types that you see, but sometimes, there's monthly or
six-month income statements. And the general format is pretty
consistent, although there is a lot of variation
depending on what a business does, but in this video, I
really just want to cover almost a plain vanilla income
statement for a company that just sells a widget. So the first thing when you sell
a widget is you make it and you just sell it. You sell the widget. You give a customer a widget,
and they give you some money. And that money that they give
you– and I'm not going to get too technical about the
accounting right now– is considered revenue.

It's sometimes considered
sales. And that's literally the money
that they give you at a certain period of time. And some of you accountants out
there are like, oh, well, no, that's not just the money
that they give you. It's the money that you've
earned in a certain period of time, and that's true. But for our sake, let's just
say that when you give the widget, you have earned the
money that they give you, and that's revenue sales. Later on, we'll talk about
different ways to account revenue and sales. So let's say the revenue or the
sales in this case in a given period, let's say
that this is an income statement for 2008.

So over 2008, we sold
let's say $3 million worth of widgets. So let's say it's $3 million. And a lot of times when you look
at income statements for companies, if you go to Yahoo! Finance, you could do this right
now, instead of writing $3 million, you'll
see $3,000 there. It's like, oh, my God! This company, they're hardly
selling anything. But it's kind of a standard that
they tend to write things in thousands.

So 3,000 would be
3,000 thousands, which would be 3 million. And for really big companies,
they actually sometimes write their numbers in millions. So if you saw 3,000 there, it
would actually mean 3 billion. But we'll actually look at real
income statements in the not-too-far-off future. So that's how much money
they give us. But that's not how much income
we made, because there was a lot of cost that went into
making that widget that we have to account for. It's not like when someone gives
me $3 million, I can just say, oh, I made
$3 million. Let me just put it
all in the bank. I'm done. That was all income. So the first thing that you
tend to see on an income statement is the cost of those
actual widgets, the cost of producing those widgets.

And I'll put all my expenses
in magenta. So it'll sometimes be written
as cost of sales or cost of goods sold. And this is literally– well,
there's two things. There's a variable cost which
is, each widget, they might have used some amount of metal
and some amount of energy to produce it and some
amount of paint if it's a painted widget. And so that the cost of goods
is literally how much did it cost to buy the metal and the
paint and provide the electricity to make those $3
million worth of widgets. That's the variable cost. And
then on top of that you have the fixed costs, or the
relatively fixed costs, where just to have the factory open,
it costs a certain amount of money every year, regardless of
how many widgets you make. And we'll go into more detail
on that, But for simplicity, let's say all those costs
of making the widgets were $1 million.

So sometimes someone might say
it's a $1 million cost. When I make models, I like to put
a minus there, so that I remember that that's a cost.
Anything that detracts from income I put as a minus. Anything that adds is a plus,
although that's not necessarily the standard
convention. Some people say, oh, it's a
positive $1 million cost, which means you subtract. But either way I think
you get the point. And then if you subtract your
costs from your revenue, or if you just add these two numbers,
because this one is negative, you have your
gross profit. And in this case, it would
be $2 million. And this number tells you, how
much money did you make, or how much profit did
you make just from selling these widgets? So the more widgets you sell,
in most circumstances, the larger this number
is going to be.

So this is your profit before
all of the other expenses that a company has to incur,
like the taxes and the CEO's salary. The CEO's salary doesn't
go in here, right? Because the CEO doesn't go out
there to the factory in most cases and actually help
make the widget. So the CEO's salary or the
CFO's salary or the headquarters in a nice
skyscraper, that doesn't get factored in here.

Or the marketing
expense, right? You have to tell people, hey,
we make good widgets. So none of that is
factored in here. So that goes into
the next line. And oftentimes, you'll see it
broken up, where they'll have marketing expense. Sometimes you have to pay
salespeople, so you might have sales expense, and then the
stuff like the corporate office and the CEO's salary, and
you have to hire auditors and accountants and
all of that. That might be included
as general. Actually, I should be doing this
in magenta because it's all expenses.

Marketing, sales, and then
G&A you'll sometimes see. Sometimes you'll see SG&A. G&A just stands for general and
administrative expenses. If you see SG&A– sometimes
instead of that you'll see SG&A– that mean selling,
general and administrative expenses. Selling is things like, it could
be the commissions that the salespeople get. It could be just the cost of
having salespeople travel around the country and taking
people out to steak dinners. And then the general and
administrative, that's just all the stuff that the corporate
office does, and all the people who are
at that level. So if you subtract these, and
I'm just making up these numbers as I go. Say, in marketing, the company
is spending $500,000.

And I'm putting it as a minus
because I like to remember it's an expense. Some models you'll
see, they'll say it's $500,000 expense. Sales, let's say, this
is just G&A here. I want to make a separate
line for sales. So let's say sales, selling
expenses is $200,000. And let's say G&A, the corporate
offices and all of that, let's see that's
another $300,000. And now we're ready to figure
out how much money did the operations of this
business make? So this is operating profit. This is really important to pay
attention to, because so many people say, oh, a company
made this much.

And you'll hear these numbers,
gross and operating profit and net profit and pretax profit,
and it's very hard to understand that these are
actually very, very different things, because they all have
the word "profit," and what does gross and operating
and all that mean? But here you see it means very,
very different things. Let's calculate this number
first before I go off on one of my tangents on all the
differences between the operating and the
gross profit.

But let's see, 2 million
minus 1 million. My head I think implicitly
made the numbers work out nicely. So my operating profit
here is $1 million. So already we have some
new nuance on profit. I made $2 million just from
actual widget sales, but then when you take out all of the
overhead of the company, the marketing, the sales, the
general and administrative expenses, I'm only left
with $1 million. And this is the profit from the
operations of the company, or you could say from the assets
or from the business or from the enterprise
of the company. That's what it is generating. But we can see– I've drawn a
bunch of balance sheets before and I think this is a good time
to draw a balance sheet. So you have kind of the
assets of a company. And we'll talk a little bit
more about assets and enterprise value, and there's
a little bit of a nuance there, but essentially
the company itself. Before you think about how the
company is paid for or how it's funded, if you just think
about the enterprise itself, the assets.

The assets are generating
this. They're generating the operating
profit, and that's a very important thing to realize
in the future when we talk about return on assets. Actually, we could talk
about it now. Let's say our assets, if we
paid $10 million for these assets, and these assets– this
is the income statement for 2008– are spitting out $1
million a year, or at least $1 million in this year, our return
on asset– I wasn't planning on introducing this,
but it doesn't hurt to introduce it right now– our
return on asset, often acronymed ROA, would be– well,
the numerator is the return, which is $1 million.

The denominator is the
assets, $10 million. So we got a 10% return
on our assets. For a $10 million investment,
we're getting $1 million a year. We're getting 10% of our asset
investment back every year. So that's a nice thing to keep
in the back of your mind, this return on asset concept, and
it's very closely tied to operating profits and the
actual assets of a firm. What we've learned, and
especially if you watched some of my other economics videos,
that all companies aren't financed the same. A lot of them might
have some debt. So let's say that company had
$10 million of assets, but let's say they paid for it
with $5 million of debt. And let's say the interest rate
on that debt is– let me think of a good number– 5%.

Let's make it easier. Let's make it 10% interest. So this is the operating
profit. This is the money that just
comes out of the asset itself. But, of course, that's not the
money that we get to take home, because we have to pay
this interest. So let's throw that in there as an expense. Interest expense. And obviously, a company that
has no debt will have no interest expense, but
in this case, we do. And this is an annual
income statement. So let's see, if we have $5
million of debt, and we're paying 10% on that, 10% of $5
million is $500,000 a year in interest. So we have to
essentially take half of our operating profit and give
it back to the bank. And now we are left with our–
we're getting close to where we need to get to–
pre-tax income. And if we do the subtraction,
we're at $500,000. And you could guess what the
next line is going to be, given that this says pre-tax. This is what the owners of the
company get before they pay the government. So you can guess what
the next line is.

It's going to be taxes. Let's say that it's a 30%
corporate tax rate, and you're going to take 30% of this
number right here. 30% of that number
right there. So 30% of $500,000
is $150,000. And then we are done. We finally have paid off
everybody we need to pay off. So we started off with
$3 million up here. We kept paying a bunch of
expenses, and then now we're left with what? This is $350,000
of net income. And this is what goes to the
owners of the company.

This net income right here. So going back to our balance
sheet, we had a $10 million asset, we had $5 million
of debt. We know what's left over
is the equity. So let me do that in
a vibrant color. Equity is what's left over. So let's say this is
all book value. So we have $5 million
of equity. And when I say book value,
that's just a fancy way of saying this is what our
accountants say that we paid for the stuff. This is what we have
on our books. And we'll talk later about
depreciation and amortization and how we might change what
these values are, but a very simple way is, if you went out
and bought $10 million worth of stuff, you'd write on
your books, I have a $10 million asset. And if you took a $5 million
loan, then what you really own, if you were to kind of sell
all of this, you would get $5 million of equity.

And I think this is an
interesting thing. When we did return on asset,
we looked at the operating profit, because this is what our
company generated before we paid the bank or Uncle Sam
or anything like that. And so we took this number as
the numerator and we divided by the number of assets. Now we can do another notion,
and that's return on equity. In return on equity, the
numerator is the net income that we got, so it's $350,000. And the denominator here is the
equity, the book value of our equity, so that's
$5 million. One, two, three. One, two, three. Let's cancel some zeroes out. So it's like 35/500.

35/500 is the same thing
is 7/100, so it equals 7% return on equity. And that's interesting because,
well, why that's lower is– well, I don't want
to go into too much depth because I realize I'm already
pushing my time limit. But at this point, you should
have a good understanding of at least a basic income
statement of a company that sells widgets. And in the future, we're gonna
look at a lot of different companies, financial companies,
insurance companies, natural gas pipeline
companies, that will have very different-looking
income statements, but this gives you the general template
for how things work.

And at least it'll give you a
sense of how revenues, gross profit, operating profit,
pre-tax income and net income really are different. A lot of times in the
popular press. They're all jumbled up as just
kind of the company is making this much money. Anyway, I'll see you
in the next video..

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