The Income Statement
The income statement is a summary of the profitability of the firm over a period of time, such as a year. It presents revenues generated during the operating period, the expenses incurred during that same period, and the company’s net earnings or profits, which are simply the difference between revenues and expenses.
It is useful to distinguish four broad classes of expenses: cost of goods sold, which is the direct cost attributable to producing the product sold by the firm; general and adminis- trative expenses, which correspond to overhead expenses, salaries, advertising, and other costs of operating the firm that are not directly attributable to production; interest expense on the firm’s debt; and taxes on earnings owed to federal and local governments.
Table 19.1 presents a 2009 income statement for Hewlett-Packard. At the top are the company’s revenues from operations. Next come operating expenses, the costs incurred in the course of generating those revenues, including a depreciation allowance. The differ- ence between operating revenues and operating costs is called operating income. Income or expenses from other, primarily nonrecurring, sources are then added or subtracted to obtain earnings before interest and taxes (EBIT), which is what the firm would have earned if not for obligations to its creditors and the tax authorities. EBIT is a measure of the profit- ability of the firm’s operations, ignoring any interest burden attributable to debt financing.
The income statement then goes on to subtract net interest expense from EBIT to arrive at taxable income. Finally, the income tax due the government is subtracted to arrive at net income, the “bottom line” of the income statement.
Analysts also commonly prepare a common-size income statement, in which all items on the income statement are expressed as a fraction of total revenue. This makes it easier to compare firms of different sizes. The right-hand column of Table 19.1 is HP’s common- size income statement.
The Balance Sheet
While the income statement provides a measure of profitability over a period of time, the balance sheet provides a “snapshot” of the financial condition of the firm at a particular moment. The balance sheet is a list of the firm’s assets and liabilities at that moment. The difference in assets and liabilities is the net worth of the firm, also called shareholders’ or stockholders’ equity. Like income statements, balance sheets are reasonably standardized in presentation. Table 19.2 is HP’s balance sheet for 2009.
Note: Sums subject to rounding error.
Source: Hewlett-Packard Annual Report, year ending October 2009. © 2009 Hewlett-Packard Development Company, L.P.
$ Million
Percent of Revenue Operating revenues
Net sales $114,552 100.0%
Operating expenses
Cost of goods sold 82,751 72.2
Selling, general & administrative expenses 11,613 10.1
Research & development expenses 2,819 2.5
Depreciation 4,773 4.2
Operating income 12,596 11.0
Other income (expense) (2,460) 22.1
Earnings before interest and income taxes $10,136 8.8%
Interest expense 721 0.6
Taxable income $ 9,415 8.2%
Taxes 1,755 1.5
Net income $7,660 6.7%
Allocation of net income
Dividends 766 0.7
Addition to retained earnings 6,894 6.0
Table 19.1
Consolidated statement of income for Hewlett- Packard, 2009
Assets$ MillionPercent of Total AssetsLiabilities and Shareholders’ Equity$ MillionPercent of Total Assets Current assets Cash and marketable securities$13,33411.6%Current liabilities Receivables19,21216.7Debt due for repayment$ 1,8501.6% Inventories6,1285.3 Accounts payable33,86229.5 Other current assets13,86512.1Other current liabilities 7,291 6.4 Total current assets$52,53945.8% Total current liabilities$43,00337.5% Fixed assetsLong-term debt13,98012.2 Tangible fixed assetsOther long-term liabilities17,29915.1 Property, plant, and equipment$11,2629.8% Long-term investments11,289 9.8Total liabilities74,28264.7 Total tangible fixed assets$22,55119.6%Shareholders’ equity: Intangible fixed assetsCommon stock and other paid-in capital10,5819.2 Goodwill$33,10928.8% Retained earnings 29,936 26.1 Other intangible assets 6,600 5.7 Total shareholders’ equity$40,51735.3% Total intangible fixed assets$39,70934.6%Total liabilities and shareholders’ equity$114,799100.0% Total fixed assets62,26054.2 Total assets$114,799100.0% Table 19.2 Consolidated balance sheet for Hewlett-Packard, 2009 Note: Column sums subject to rounding error. Source: Hewlett-Packard Annual Report, year ending October 2009. © 2009 Hewlett-Packard Development Company, L.P.
The first section of the balance sheet gives a listing of the assets of the firm. Current assets are presented first. These are cash and other items such as accounts receivable or inventories that will be converted into cash within 1 year. Next comes a listing of long-term or “fixed” assets. Tangible fixed assets are items such as buildings, equipment, or vehicles.
HP also has several intangible assets such as a respected brand name and expertise. But accountants generally are reluctant to include these assets on the balance sheet, as they are so hard to value. However, when one firm purchases another for a premium over its book value, that difference, called “goodwill,” is listed on the balance sheet as an intan- gible fixed asset. HP has unusually high goodwill because of its acquisition of Compaq Computer several years ago. 1 The sum of current and fixed assets is total assets, the last line of the assets section of the balance sheet.
The liability and shareholders’ equity (also called stockholders’ equity) section is arranged similarly. First come short-term, or “current,” liabilities such as accounts pay- able, accrued taxes, and debts that are due within 1 year. Following this is long-term debt and other liabilities due in more than 1 year. The difference between total assets and total liabilities is stockholders’ equity. This is the net worth, or book value, of the firm.
Stockholders’ equity is divided into par value of stock, additional paid-in capital, and retained earnings, although this division is usually unimportant. Briefly, par value plus additional paid-in capital represent the proceeds realized from the sale of stock to the pub- lic, whereas retained earnings represent the buildup of equity from profits plowed back into the firm. Even if the firm issues no new equity, book value typically will increase each year due to reinvested earnings.
The first panel in the balance sheet in Table 19.2 presents the dollar value of each asset.
Just as they compute common-size income statements, however, analysts also find it con- venient to use common-size balance sheets when comparing firms of different sizes. Each item is expressed as a percentage of total assets. These entries appear in the right columns of Table 19.2 .
The Statement of Cash Flows
The income statement and balance sheets are based on accrual methods of accounting, which means that revenues and expenses are recognized at the time of a sale even if no cash has yet been exchanged. In contrast, the statement of cash flows tracks the cash implications of transactions. For example, if goods are sold now, with payment due in 60 days, the income statement will treat the revenue as generated when the sale occurs, and the balance sheet will be immediately augmented by accounts receivable, but the statement of cash flows will not show an increase in available cash until the bill is paid.
Table 19.3 is the 2009 statement of cash flows for HP. The first entry listed under cash flows from operations is net income. The next entries modify that figure for components of income that have been recognized but for which cash has not yet changed hands. For example, HP’s accounts receivable increased by $549 million in 2009. This portion of sales was claimed on the income statement, but the cash had not yet been collected. Increases in accounts receivable are in effect an investment in working capital, and therefore reduce the cash flows realized from operations. Similarly, increases in accounts payable mean that expenses have been recognized, but cash has not yet left the firm. Any payment delay increases the company’s net cash flows in this period.
1 Firms are required to test their goodwill assets for “impairment” each year. If the value of the acquired firm is clearly less than its purchase price, that amount must be charged off as an expense. AOL Time Warner set a record when it recognized an impairment of $99 billion in 2002 following the January 2001 merger of Time Warner with AOL.
Another major difference between the income statement and the statement of cash flows involves depreciation, which is a major addition to income in the adjustment section of the statement of cash flows in Table 19.3 . The income statement attempts to “smooth”
large capital expenditures over time. The depreciation expense on the income statement does this by recognizing such expenditures over a period of many years rather than at the specific time of purchase. In contrast, the statement of cash flows recognizes the cash implication of a capital expenditure when it occurs. Therefore, it adds back the deprecia- tion “expense” that was used to compute net income; instead, it acknowledges a capital expenditure when it is paid. It does so by reporting cash flows separately for operations, investing, and financing activities. This way, any large cash flows, such as those for big investments, can be recognized without affecting the measure of cash provided by operations.
The second section of the statement of cash flows is the accounting of cash flows from investing activities. For example, HP used $3,695 million of cash investing in tangible fixed assets. These entries are investments in the assets necessary for the firm to maintain or enhance its productive capacity.
Finally, the last section of the statement lists the cash flows realized from financing activities. Issuance of securities will contribute positive cash flows, while repurchase or redemption of outstanding securities uses up cash. For example, HP expended
Source: Hewlett-Packard Annual Report, year ending October 2009. © 2009 Hewlett-Packard Development Company, L.P.
$ Million Cash provided by operations
Net income $ 7,660
Adjustments to net income
Depreciation 4,773
Changes in working capital
Decrease (increase) in receivables (549)
Decrease (increase) in inventories 1,532
Increase (decrease) in other current liabilities 580 Changes due to other operating activities (617)
Total adjustments $ 5,719
Cash provided by operations 13,379
Cash flows from investments
Gross investments in tangible fixed assets (3,695)
Investments in other fixed assets 104
Investment in other assets 11
Cash provided by (used for) investments $(3,580) Cash provided by (used for) financing activities
Additions to (reductions in) long-term debt (2,766)
Net issues (repurchases of) shares (3,303)
Dividends (766)
Other 162
Cash provided by (used for) financing activities $(6,673)
Net increase in cash 3,126
Table 19.3
Statement of cash flows for Hewlett-Packard, 2009
$3,303 million to repurchase shares of its stock in 2009, which was a major use of cash. Its dividend payments, $766 million, also used cash. In total, HP’s financing activities in 2009 absorbed $6,673 million.
To summarize, HP’s operations generated a cash flow of $13,379 million. Some of that cash flow, $3,580 million, went to pay for new investments. Another part, $6,673 mil- lion, went to pay dividends and retire outstanding securities. HP’s cash holdings therefore increased by $13,379 2 $3,580 2 $6,673 5 $3,126 million. This is reported on the last line of Table 19.3 .
The statement of cash flows provides important evidence on the well-being of a firm. If a company cannot pay its dividends and maintain the productivity of its capital stock out of cash flow from operations, for example, and it must resort to borrowing to meet these demands, this is a serious warning that the firm cannot maintain the dividend payout at its current level in the long run. The statement of cash flows will reveal this developing problem when it shows that cash flow from operations is inadequate and that borrowing is being used to maintain dividend payments at unsustainable levels.