An income statement, one component of a set of financial statements, provides a snapshot of a company’s profitability over a specific period of time by deriving net income from sales. While an income statement may help its user obtain a general sense of whether the company was profitable or not, it should not be relied on as the sole basis for determining the value of the company. It is especially important that users of financial statements (i.e. potential investors, lenders, creditors, members of companies, boards of directors, and potential purchasers of the company) understand how the income statement was prepared to make a determination regarding the company’s financial performance for the period being examined, the company’s credit worthiness, and its value. Income statements may obscure true long-term financial performance by the nature of their presentation, and financial results that appear clear may be hiding issues beneath the surface. Investing time and asking the right questions will give the user an appreciation of what is not there, as well as what is not quite there, and should help guide further review of a company’s condition and prospects. To dispel the murkiness, it is important for income statement users to know what information is presented on an income statement, the limitations of that presentation, and what information can not be found on an income statement at all. In this article, real-world examples illustrate some of the issues that may arise for income statement users.
First, a user should understand the information provided in an income statement. The following is a sample income statement:
An income statement includes three principal components: sales (and related expenses), operating expenses, and miscellaneous income and expenses (such as interest). These measurements provide a baseline tool for understanding how the company generates money to fund its operations. Typically, the sales section lists revenue streams followed by contra-revenue accounts, such as sales discounts and returns and allowances. Then the associated expenses (cost of goods sold, or COGS) are listed in the same order as the revenue streams so that the user may easily match each stream to its associated expenses. For example, if Product A generates the largest sales in terms of dollars – and is therefore listed first – then the COGS for Product A would be the first listed under the associated revenue expenses. The operating expense section shows expenses related to the operations of the business, such as rent, insurance, utilities, and salaries. Note that these are not tied to product development and production. Operating expenses are typically listed in descending order in terms of dollars spent. The miscellaneous section of the income statement can be presented in many ways and contain items such as interest income and expenses, gains and losses on fixed asset sales, and equity compensation. The amounts are typically presented in descending order based on dollar amount.
It is important to remember that the income statement is a reflection of the operations of the company over a period of time. Depending on the time period covered, the results can be vastly different. For example, for a company that manufactures toys, income statements from different time periods can vary greatly. A six-month income statement for the period from January through June of a given year would likely show that the company is not profitable and is losing significant amounts of money. This six-month income statement would likely include:
The income statement might also include large bonus payouts for the prior year’s sales volume. However, it would likely not include large sales amounts for sales that would occur during the holiday season when the toy manufacturer does most of its business. No one would argue that this income statement is an accurate representation of the company’s year-round operations, even though it would be accurate from an accounting standpoint. A six-month income statement for the second half of the year (July through December) would show a seemingly different company:
The company would likely look very profitable in this statement, with large sales numbers, disproportionately low returns and/or costs of goods sold to reduce the sales, operating expenses that appear reasonable, and a large profit number. However, this income statement does not accurately reflect the operations of the company – it only provides a partial guide. The picture becomes clearer when you see an income statement for the entire year (January through December), including both the lows of the first six months and the highs of the last six months, and net them against each other to determine the company’s operations for the entire period. Furthermore, comparative income statements – income statements that compare similar periods to one another – provide additional insight into a company’s operations to help identify any irregularities. This kind of comparison provides an additional data point for income statement users to begin an inquiry into what a “normal” operation would look like, including what would be the appropriate level of reserves.
Users who do not dig into the information presented on an income statement may be seeing only part of the story. This section discusses some things users need to look for while reviewing income statements, and provides real world examples of the ways that hidden truths can be lurking behind each section. Remember that some flexibility is afforded in the preparation of an income statement, and, therefore, income statements may be presented differently by different companies.
Sales are the key to a business’s ability to continue operating. However, the sales reflected on the income statement do not provide the reader with the whole story. All sales are not created equal. Factors to consider:
Additionally, companies may book sales as early as possible (sometimes before the production or shipping of goods has begun) in order to meet period sales goals, as well as to boost the company’s overall financial picture. In this case, income statement users should ask what procedures were undertaken by the company to ensure an accurate cutoff of reporting.
First, a company shipped goods to distributors that were neither ordered by the distributors, nor made to those distributors’ quality standards. The company booked the sale at period end, and incorporated the sale into its annual financial statements in order to look more profitable and to appear to have a higher sales volume. Fast-forward to the subsequent year, and the company showed huge returns from those distributors – offsetting all of the increased sales of the prior period. Ina second example, a company liquidated a portion of its inventory below market value (and sometimes below cost) to generate cash to satisfy its operational expenses. While sales appeared steady, this was obviously not a sustainable business model. Without a deep dive into the product-level margins, this tactic might not be discovered.
COGS are the expenses directly associated with the production of the goods the company produces. Typically, there is little fluctuation in the price of the components of the goods that are sold. However, this is not always the case. Commodity price fluctuations and purchase discounts can greatly impact COGS, leading to lower gross margins. For example, a company that uses copper in its production may find that the price it pays fluctuates with the commodity trading markets. Depending on whether a company uses LIFO (last in first out) or FIFO (first in first out), or another accounting method, this price fluctuation will impact COGS. So, if the price of copper fluctuates between $50 per unit and $75 per unit, and the unit sells for $100, the profit margin on that item could vary by as much as $25 based solely on the accounting convention used. Therefore, depending on the company’s inventory method, COGS may not reflect current material costs that will impact gross margins in subsequent periods.
Operating expenses are the normal expenses businesses incur that are not directly related to the production of the company’s products. Indirect selling expenses such as rent, salaries, factoring charges, and professional fees are all operating expenses. Because of the potential for hidden truths in these areas, income statement users should consider all operating expenses carefully.
Users should examine a company’s leases to determine 1) if the landlord is a related party or not and 2) if the company is paying the market rate for rent. If the company is not paying market-rate rent, is the rate more favorable or less favorable to the company? Also, to determine what the company’s long-term outlook is, a user should ask about the terms and length of the lease: Will the company need to renegotiate the lease in the next year or move? Is it locked into a 10-year lease with significantly above-market rates? Is there a mortgage on the property, or is the rent payment going directly into the landlord’s pocket (this may not be known if it is not a related-party lease)?
One company owned a building that was used for operations by several company-owned entities. The company then charged rent to some, but not all, of these entities. Therefore, rent was reflected on certain entity income statements but not others. From the perspective of a user looking at any of the entities on a stand-alone basis, the income statements were either overstated or understated due to rent expenses.
When looking at salaries, questions to ask include:
Audited financial statements may include some of these items in their accompanying notes section. For companies without audited financial statements, it is appropriate to ask these questions.
A company routinely made salary payments to an owner’s brother for services rendered. An investigation determined that the brother spent no time working for the company: He never set foot on the company’s premises, and he never made efforts that benefitted the company in any way. Viewing the payments to the brother as salary had a dual impact. First, the salary was improper. Second, a cursory analysis might have indicated appropriate staffing where, in fact, there were holes. For example, someone using industry standard ratios might incorrectly assume the staffing was in line with industry norms based on a headcount and total weekly salaries. Additionally, some industries have prescribed minimum staffing levels (for example, a nurses-to-patients ratio), and if the brother was included in this calculation despite not actually performing services, the ramifications would be significant.
When you see factoring charges on an income statement, the company is using a third party to help in its cash management process. A factor is typically a lender that buys accounts receivable at a discount, collects the accounts receivable, and profits from the difference between the face value of the account receivable and the discounted amount it paid. Additionally, factors typically negotiate the right to sell back uncollectable accounts receivable, as well as to charge interest and loan fees on the amounts advanced to the client. A company may need these services for a variety of reasons, including:
Improving the cash management process can typically improve profitability. The use of a factor may trigger an analysis of whether a small one-time cash infusion to bridge the gap between customer payments is worth more than the value lost to the factor. Some additional analysis should be performed to determine what cash management processes and procedures are in place and how they can be improved to potentially improve cash flow. Is there an issue with customers taking too much time to pay their invoices? Can revised terms be worked out with these customers? Could the company offer a discount for early payment?
One company with slow-paying government customers used a factor to help manage its monthly cash flow. The company needed to purchase consumables weekly, and was paid much less frequently. Due to the competitive nature of the business and the rigidity of the customer, the invoices could not be paid more quickly. One problem with using a factor is that sometimes the customer sends payment to the company and not to the factor, which makes the account receivable the factor purchased from the company uncollectable. Sometimes the company turns the funds over to the factor, but not always. In this case, the company allegedly received direct payments from customers and failed to remit the funds to the factor. When the factor approached the customer about paying the outstanding invoice, the customer refused to reissue payment and instead produced cancelled checks. This was a balance sheet issue for the company because of the potential impact on accounts receivable, factoring charges, and other balance sheet entries. If the company had booked those receipts as additional cash sales (despite them being merely “phantom” sales), it would have increased sales and thereby decreased average COGS on the balance sheet. This would have made the company look more profitable than it was. The lesson here for income statement users is to perform due diligence.
Professional fees include fees for the company’s accountants, lawyers, and other third-party professionals. Professional fees on an income statement offer one of the most telling accounts of a company’s operations. This section of the income statement shows who is assisting the company and what services they are providing. For example, while statement users might expect to see fees for an employment lawyer or a collection lawyer, fees for a criminal defense or patent litigation law firm might raise concerns because those could signal either regulatory violations or that competitors are knocking off the company’s products. Also, the professional fees will allow users to identify the company’s independent accountant and valuation firms, which can be helpful in analyzing whether the numbers presented on the income statement are reliable. While the income statement may not provide this level of detail about professional fees, it is appropriate to make an inquiry to view the company’s books and records where these details will be recorded.
A company looking for investors to contribute up to $100 million in new financing to grow its business into a national clothing line hired a sole proprietor auditor from the other side of the country to perform the audit and issue an auditor’s opinion letter that was to be included in the investor packages. After a due diligence review uncovered this fact, potential investors started reaching out to the auditor to address additional due diligence items that they wanted included in the opinion letter. It was only then that the potential investors learned that the auditor was a fictional creation. The auditor did not exist, and the opinion letter was fraudulently fabricated by the company’s management – as were the “audited” financial statements. This demonstrates that looking behind innocuous representations is an important part of the due diligence process. Here, the amount of the accounting expense shown on the financial statements was immaterial compared to the potential damage that was subsequently uncovered – a fictional auditor and financial statements.
Other income on an income statement includes:
Due diligence should be considered on these types of line items to verify that the income is generated from normal ongoing business operations. For example, litigation proceeds or the net proceeds generated by the sale of a division of the company can produce other income that typically would not be replicable.
An income statement presents information to give a snapshot of the operational results for a given period to help understand the financial performance of a business. There are many ways in which what appears to be a straightforward presentation of operational results could be misleading. It is critical that income statement users perform due diligence not only to measure how a business has operated and as an indicator of how it may perform in the future, but also to understand if there are issues that require further inquiry. Profitability can be masked to tell the story the company elects to tell while still conforming to generally accepted accounting principles. It is wise to spend time and resources at the outset of a potential acquisition to uncover issues, rather than suffer losses and disappointment when the truth bares itself. Beneath the surface of an income statement is information essential to gaining a better grasp of the nuances of the company’s business.
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Michael Schwarzmann has over 17 years experience providing advisory services to companies and their constituents, utilizing his legal and financial background to assist in identifying issues and implementing meaning value-added solutions. Michael has assisted clients in developing and evaluating business and turnaround plans, analyzing financial and operational performance, and formulating successful strategies to preserve or…
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