Michael Taillard - Corporate Finance For Dummies

Income tax expense: Like people, companies must pay taxes on the income they generate. The amount of income taxes a company pays is based on their EBT (earnings before tax, but not interest). So if a company makes $100 in a tax year and it has to pay 6 percent in income tax, then it has to pay $6. Many companies also list the percentage of income taxes in this section, but it isn’t required.

Net income is calculated by taking EBIT and subtracting all interest and tax expense. Simply put, the net income is the final amount that a company walks away with after it has considered all costs. It includes all revenues and all costs and represents the final profits that a company was able to generate during the period. The company must either distribute the money from net income to its stockholders (who own the company) or reinvest it into the company for improvements and expansion. Either way, the money from net income belongs to the company owners and must contribute to the value of their ownership in the company.

In the portion of the income statement immediately following net income, corporations have to include the amount of earnings each share of stock they have outstanding has generated. Here are the two main components of this portion, aptly called earnings per share (EPS):

Basic earnings per share: Companies calculate the basic earnings per share by dividing net earnings by the total number of common shares outstanding. This calculation tells investors how much money each share of stock they own earned during the period. For example, if a company made $1,000 during a year and has a total of 1,000 shares of stock, then everyone who owns that company’s stock made $1 per share of stock.

Diluted earnings per share: Companies can issue a number of options that can eventually turn into common stock. For example, company employees may be given stock options, or preferred shares and convertible bonds may be converted into common stock. The diluted earnings per share does the same thing as basic earnings per share except that it assumes all these different holding options have been turned into common shares. So a company that made $1,000 and has 1,000 shares of stock has an earnings per share of $1. But if that company also has 1,000 shares of convertible preferred stock, its diluted earnings per share is $0.50.

Sometimes events that alter a company’s income occur but don’t have a place on the income statement or require additional comments. Anything of this sort goes in the supplemental notes portion of the income statement. Examples include the following:

A switch from LIFO inventory cost accounting to FIFO inventory cost accounting

An unusual or infrequent event, such as finding an oil reserve where your new building is being constructed and selling it for extra revenues

Any discontinued operations or unusual earnings from subsidiaries

By itself, the information you find in the income statement is great for tracking expenses and revenues, corporate revenue management, and dividend policy. But you can find out even more by comparing the same company’s income statements over a series of years. In fact, by watching for trends in a company’s income statements, you can identify successes or problems with specific operations that generate costs relative to the amount that the operations contribute to generating revenues. And, of course, you can compare the income statement of one company to the income statements of other companies in the same industry to determine how competitive that company is within the industry as well as how it should position itself regarding price and volume of output.

When used in conjunction with other financial statements, the income statement contributes to a number of metrics that measure how effectively a company’s management manages its assets and how well the company yields returns on those assets. Investors can use these metrics to determine whether the company is generating income and wealth on their share of the ownership in the company and whether the company is holding excessive levels of debt that could endanger the value of their ownership sometime in the future. I discuss these different metrics in Chapters 7and 8.

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