Lita Epstein - Reading Financial Reports For Dummies

Purchase returns and allowances: This account tracks any transactions involving the return of any damaged or defective products to the manufacturer or vendor.

Freight charges: This account tracks the costs of shipping the goods sold.

Any costs not directly related to generating revenue are considered expenses. Expenses fall into four categories: operating, interest, depreciation or amortization, and taxes. A large company can have hundreds of expense accounts, so I don't name each one. Instead, I give you a broad overview of the types of expense accounts that fall into each of these categories:

Operating expenses: The largest share of expense accounts falls under the umbrella of operating expenses, which include advertising, dues and subscriptions, equipment rental, store rental, insurance, legal and accounting fees, meals, entertainment, salaries, office expenses, postage, repairs and maintenance, supplies, travel, telephone, utilities, vehicle expenses, and just about anything else that goes into the cost of operating a business and isn't directly related to selling a company's products.

Interest expenses: Interest paid on a company's debt is reflected in the accounts for interest expenses — credit cards, loans, bonds, or any other type of debt the company may carry.

Depreciation and amortization expenses: I discuss how depreciation is calculated in “ Depreciation and amortization,” earlier in this chapter. The process for amortization is similar. The depreciation and amortization accounts track the amount written off each year for any type of asset, and the income statement shows expenses related to depreciation and amortization in each individual year.

Taxes: A company pays numerous types of taxes. Sales taxes aren't listed in the expense area because they're paid by customers and accrued as a liability until paid. Taxes withheld from employee paychecks are also accrued as a liability and aren't listed as an expense. The types of taxes that are expenses for a company include the employer's half of Social Security and Medicare taxes, unemployment taxes and other related payroll taxes that vary depending on state, and corporate taxes, if the company has incorporated. Businesses that aren't incorporated don't have to pay taxes on income. Instead, the owners report that income on their personal tax returns. I talk more about taxes and company structure in Chapter 3.

A company doesn't actually make different kinds of profits, but it has different ways to track a profit and compare its results with similar companies. The three key profit types are gross profit, operating profit, and net profit. In Chapter 11, I discuss how these profit types can test a company's viability.

The gross profit reflects the revenue earned minus any direct costs of generating that revenue, such as costs related to the purchase or production of goods before any expenses, including operating, taxes, interest, depreciation, and amortization. The gross profit isn't actually part of the Chart of Accounts. You calculate the number for the income statement to show the profit a company makes before expenses.

The operating profit is the next profit figure you see on the income statement. This number measures a company's earning power from its ongoing operations. The operating profit is calculated by subtracting operating expenses from gross profit. Some companies include depreciation and amortization expenses in this calculation, calling this line item EBIT, or earnings before interest and taxes .

Others add an additional line called EBITDA, or earnings before interest, taxes, depreciation, and amortization. Accountants started using EBITDA in the 1980s because it gave analysts a number they could use to compare profitability among companies and eliminated the effects of financing and accounting.

Interest is a financial decision. A company has the choice to finance new product development or other major projects by selling bonds, taking loans, or issuing stock. If the company chooses to raise money using bonds or loans, it has to pay interest. Money raised by issuing stock doesn't have interest costs. I talk more about this difference and the impact on a company's profits in Chapter 11.

Believe it or not, taxes are also an accounting game. Most corporations report different tax numbers on their financial statements than they pay to the government because of various tax write-offs they're able to use to reduce their tax bill.

Companies don't actually pay out cash for depreciation and amortization expenses. Instead, depreciation and amortization are an accounting requirement that comes into play when determining the value of assets.

Net profit is the bottom line after all costs, expenses, interest, taxes, depreciation, and amortization have been deducted. Net profit reflects how much money a company makes. If the company isn't incorporated, it can pay out the profit to shareholders or company owners, or it can reinvest the money in growing itself. Firms add reinvested money to the retained earnings account on the balance sheet.

Part 2

IN THIS PART …

Discover the parts of an annual report and look at how to summarize financial information.

Check out assets, liabilities, and equity, and see how to review and examine them to keep things in balance.

Understand how to use income statements to determine whether a company has made a profit.

Look at statements of cash flows to determine whether the company has enough cash to operate.

Read behind the numbers and scour financial reports for red flags.

Understand consolidated financial statements and look at ways companies buy other companies.

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