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THE 3 PROFITS of the INCOME STATEMENT…do you know them? Yes, understanding Financial Statements is an essential business skill. In this Podcast we continue our deconstruction, decoding and deciphering of the key financial statements. Last episode we dug into the Balance Sheet. I hope you found that episode insightful. If you haven’t heard it yet no worries, check it out when we finish here! This Episode is about the INCOME STATEMENT. The Income Statement goes by many other names and aliases, Profit and Loss Statement, the P&L, Revenue Statement, Statement of Financial Performance, Earnings Statement or Statement of Earnings, Operating Statement, or Statement of Operations…geeezzzz, enough already, if one name wasn’t hard enough to remember. I’ll stick with calling it an Income Statement, but my lenders and banker’s always ask me for our P&L. Of all the financial statements this is the one you are probably most aware of and check because is contains one number everyone wants to know…. THE BOTTOM LINE or NET PROFIT. This number is the easiest to locate, because it’s at the bottom line of the Income Statement. You probably dash there when the reports arrive, eager to see how the practice did. Hopefully you don’t find a number bracketed by parentheses signifying a loss. What’s up with that? That doesn’t make any sense, how can one have negative money? You know there is money in the bank account because you just checked! You say to yourself I never understood those dagnabnett accounting reports and financial statements any way and carry on with business as usual. If there is a BOTTOM LINE, there must be a TOP LINE…correct you are! And a MIDDLE too! So let’s starting deconstructing the INCOME STATEMENT! An Income Statement contains three sections: TOP LINE: shows you your total REVENUE or SALES SIDE BAR here, when business folks talk of TOP LINE GROW, that’s secret code for sales growth, plain and simple. MIDDLE SECTION: reveals your COSTS and EXPENSES broken down by category. BOTTOM LINE: shows your NET PROFIT or LOSS; which is REVENUE - EXPENSES. It’s that simple, and as we learned in the Balance Sheet Podcast, it’s the NET PROFIT that connects the INCOME STATEMENT to the BALANCE SHEET since it is added to the RETAINED EARNINGS section of the BALANCE SHEET. An income statement is much like a report card. It is always calculated over a given time period, typically one month. Understanding this, we can better see that the income statement affects the balance sheet much like how an individual grade affects your GPA. The RETAINED EARNINGS section of the balance sheet accumulates all of the profits or losses in the business. This is a critically important point to highlight and understand for it is how the BALANCE SHEET and INCOME STATEMENT are connected. So, back to the most important feature of the INCOME Statement, the calculation of PROFIT! Your MISSION, should you choose to accept it, is to Learn what all the line items on the income statement are, and how to manage them. With this knowledge you will know how to improve and contribute to the profitability of your firm. The income statement measures how profitable your products or services are when everything is added up! Remember, the bottom line Profit number is always an estimate, since estimates and assumptions sneak into some of the line items of the income statement. Just as important is the fact that PROFITS are NOT CASH! You can’t spend PROFIT, you can only spend CASH. We will look in greater detail at CASH in the next podcast on the STATEMENT of CASH FLOWS. Overtime, in a well run and managed firm, PROFITS will turn into CASH! Let’s deconstruct our INCOME STATEMENT a little further. We will start at the top line of the income statement - REVENUE or SALES. A critical element here is when is REVENUE RECOGNIZED or RECORDED. For listeners that are using a Modified Cash Basis Accounting System, then this is easy…your REVENUE is the total Payment from all sources, typically patients and insurance and is RECOGNIZED only when payments are received! For other firms and publicly traded companies that are required to follow GAAP accounting rules, REVENUE RECOGNITION can be more challenging. Let’s keep it simple for our purposes and say that a company can record a sale, or recognize revenue, only when it delivers a product or service to a customer. This is an area where accountants have great discretion and latitude, and where estimates and distortions can sneak in. For Revenue to be recognized it must have been EARNED, either a product shipped, or service work performed. The next section of the INCOME STATEMENT, the Middle Section details all your COSTS and EXPENSES. EXPENSES are divided into 2 distinct categories: Cost of Good Sold (COGS), or Cost of Services (COS) and Operating Expenses, also referred to as Sales, General, and Administrative Expenses (S,G&A), or just G & A for General and Administrative. The COGS or COS includes all the costs directly involved in producing a product or delivering a service. Typically this includes the wages of employees making a product or delivering a service and the materials or supplies used. This distinction between COGS/COS and OPERATION EXPENSES also serves as a dividing line on the income statement. You may hear executives and managers talking about ABOVE THE LINE and BELOW THE LINE. Well, this is where the line is! ABOVE THE LINE there are only 2 items, REVENUE and COGS or COS this is the GROSS MARGIN you hear “Mr. Wonderful” asking about on Shark Tank, or Marcus Lemonis preaching about on The Profit. BELOW THE LINE, we will learn next, are OPERATING EXPENSES, INTEREST, and TAXES. Why is this distinction important? Well, the items ABOVE THE LINE tend to vary more in the short term so attract more attention from managers. So, if an EXPENSE is NOT a COGS or COS then it is an OPERATING EXPENSE and appears BELOW THE LINE. These OPERATING EXPENSES are NOT directly related to making a product or delivering a service. OPERATING EXPENSES are often referred to as OVERHEAD and includes such items as rent, utilities, telephone, internet, advertising, marketing, IT, etc. Buried in OPERATING EXPENSES is DEPRECIATION and AMORTIZATION. This is an area of great confusion so let’s take a closer look at this. The first point to remember is that DEPRECIATION is treated like an EXPENSE, so can dramatically affect the PROFIT on an INCOME STATEMENT. Plain and simple, DEPRECIATION is the “expensing” of a physical asset over its useful life. AMORTIZATION is the same as DEPRECIATION but applies to INTANGIBLE ASSETS like GOODWILL. There is considerable latitude and methods for how one can depreciate ASSETS, consultation with your ACCOUNTANT is critical here. Remember too that even for the same firm, DEPRECIATION can be calculated differently for TAX accounting vs. GAAP accounting. I won’t bore you with the details here, just appreciate that DEPRECIATION can be calculated in many different ways! DEPRECIATION is the best example of what we call a NON-CASH Expense! So, what’s up with that? This is one of the most confusing and misunderstood areas of your financial statements, but critical for you to understand. The key to unlocking this confusing concept is to remember that the CASH for the asset has already been paid out! The vehicle or piece of CAPITAL EQUIPMENT was paid for at the time it was acquired, but the total expense was not recorded in that month. Instead, the expense is divided, or allocated, over its useful life….a little at a time, month by month! That’s DEPRECIATION. Again, it is important to understand there are many ways to calculate the depreciation expense. The method chosen can have a profound impact on your PROFITS reported on the INCOME STATEMENT. KEY POINT HERE! Good financial managers will match the use of an asset, or its depreciation, with the revenue it is bringing in. If the depreciation exceeds its revenue then this asset is creating a loss, if revenue exceeds its depreciation , the asset is returning a profit, a goal we should be striving for. Next, let’s look at the 3 profits; Gross Profit, Operating Profit and Net Profit. GROSS PROFIT is REVENUE minus COGS or COS , and is a key number. It tells us about the profitability of your product or service. If profitability is not achieved here it is unlikely that your business will survive long. GROSS PROFIT must be enough to cover OPERATING EXPENSES, TAXES, FINANCING and of course NET PROFIT. So what is a healthy Gross Profit? How much is enough? This will vary considerably by industry and from one company to another even in the same industry. Having metrics and reports that allow you to follow year-to-year trends will help you identify whether your profit is heading up or headed down. If Gross Profit is decreasing one needs to ask why. Are your COGS or COS rising? Is Revenue decreasing due to lower fees, discounts, or lower insurance fee schedules? Understanding why helps managers determine where to focus their attention. OPERATING PROFIT is GROSS PROFIT minus OPERATING EXPENSES, including DEPRECIATION and AMORTIZATION. This is also know by the odd acronym EBIT (pronounced EE-Bit). This stands for EARNINGS before INTEREST and TAXES. Why are interest and taxes not included you may ask? OPERATING PROFIT is the PROFIT a firm makes from running the business. Taxes don’t contribute to how well you run your business. And interest expense depends on how the firm is financed, i.e., with debt or equity which is termed its CAPITAL STRUCTURE. EBIT is a closely watched metric since it is a good gauze of how well a firm is being managed. Another metric is EBITDA (EE-bid-dah), which is Earning before interest, Taxes, Depreciation and amortization. This is thought to be a better measure of a firm’s operating efficiency since it ignores NON-CASH Charges like depreciation and amortization altogether. We have just reviewed the bias and distortions that can be introduced calculating depreciation, so with EBITDA it is ignored. Finally we have arrived at the BOTTOM LINE, or NET PROFIT, which is what’s left over after everything is subtracted, COGS/COS, operating expense, non-cash expenses, interest, and taxes. This is the same number used to calculate EPS, earnings per share, and the PRICE/EARNINGS ratio used on WALL STREET. Finally, if the INCOME STATEMENT calculates our PROFIT, then it is logical to ask how can we MAXIMIZE OUR PROFIT? That’s a great question. My friend, Jason Andrews in his new book, STARK NAKED NUMBERS, provides us a great and quick analysis of this topic. Quick side bar here, Jason is a Chartered Accountant, who like me, is passionate about business owners extracting value from their financial statement data. You can find his book on Amazon and I will include a link in the show notes for you. I receive no royalties from this endorsement. Please check out his fresh perspective on accounting and finance. Jason identifies several financial levers which one can use to increase profitability; the SALES LEVER; either increase sales volume or increase price, and the COST LEVER; reduce DIRECT and/or INDIRECT COSTS. It is surprising the impact on profitability a 10% change in these levers has on NET PROFIT…listed from greatest impact to least impact and the % change are; Sales Lever, Increase price 10% increases net profit 53%. Direct Cost, decrease 10% increase net profit 37%. Operating Cost, decrease 10% increase net profit 26%. Sales Lever, Increase Sales 10% only increases net profit 16%. So the fastest and easiest way to increase your BOTTOM LINE is to INCREASE YOUR PRICES/FEES. Creating more business, or increasing sales, has the least effect. Let’s wrap this PodCast up with some useful take away points. Only When REVENUE from Services exceeds EXPENSES can profit be achieved. Buying gadgets, gizmos, latest and greatest equipment, a new office, the list can go on and on are all irrelevant, EXCEPT if the gadgets, gizmos, latest and greatest equipment and new office creates GREATER REVENUE, or LOWER EXPENSES. This is also called VALUE CREATION when the PRICE a customer is willing to pay is greater than the COST to make the product or deliver the service. VALUE, like PROFIT, can only be achieved when products are sold and services delivered. The #1 GOAL of any BUSINESS is to CONTINUOUSLY CREATE VALUE for their CUSTOMERS! The hardest part is the CONTINUOUS and CONSTANT need to always be CREATING VALUE! ACCELERATING DEPRECIATION, as in SECTION 179 depreciation we are all familiar with, creates a LARGE DEPRECIATION EXPENSE that reduces your PROFITS, NET INCOME and RETAINED EARNINGS. This is a TAX STRATEGY plain and simple and points out the difference between TAX ACCOUNTING and MANAGERIAL ACCOUNTING. Planning for this DEPRECIATION should be done every time capital equipment is acquired, NOT AT THE VERY END OF THE YEAR at the encouragement of highly motivated SALES PERSONAL. OVERHEAD PERCENTAGE is a metric that dentists can not stop talking about and comparing! As you see from the above discussion, there is no OVERHEAD LINE ITEM on an INCOME STATEMENT. OPERATION EXPENSES come close but what items do you include or exclude? There are as many variations in calculations as there are people calculating it. For me it is a non-precise metric that can be distorted. A better metric to monitor and tract overtime is GROSS PROFIT and OPERATING EXPENSES as a PERCENT OF GROSS PROFIT. Whatever metric for overhead you choose, it becomes more powerful when tracked and compared overtime. PROFITS are not CASH. A profitable firm can run out of cash and a cash rich firm can non-profitable. So that wraps things up for this Podcast.  Hopefully you have a better understanding of the mechanics of the INCOME STATEMENT. We hope that this information has created a few “Ah Ha” moments, or stimulated some additional questions you can direct to your advisers or accountants.  We welcome your inquiry here too at OmniStar Financial.  Our contact information can be found at our website OmniStarfinancial.com  .  You will also find a link to sign up for our newsletter.  Please share this podcast if you found it helpful, and leave a review on iTunes too.  We welcome your feed back and suggestions for future podcast sessions.  You can always find me, your host, david darab, at my twitter handle, @ddarab. Thank you so very much for tuning in and listening.  We are very grateful for your time and attention and so very pleased to have you in our audience. REFERENCES: Financial Intelligence, Revised Edition: A Manager’s Guide to Knowing What the Numbers Really Mean: Karen Berman, Joe Knight, John Case: 8601406238220: Amazon.com: Gateway Stark Naked Numbers: Uncover Your Financials, Unlock Your Cash, and Unleash Your Profits: Mr Jason Frederick Andrew: 9780648424000: Amazon.com: Books