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Speaker: Marie-Lys Leschiera

Now, I would like to take some time with you to recap a few important points we saw on the income
statements. So, the income statement, what is it?

We said it is here to measure whether the company has generated a profit or was at a loss during
your period of time. Profits arise when sales are more than costs.

So, the top line of our income statement will always be the sales revenue. And we said the sales
revenue, how do we compute it? Well, basically the sales revenue is the sum of all the invoices we
have issued during the period of time.

And when are we allowed to issue invoices? Well, we're allowed to issue invoices as soon as a sale
is realised.

That is as soon as our goods or services have become the property of our customers, that's the
very important principle of realisation of sales. So, some sales can be included in the sales revenue,
even if customers have not paid us.

Then what's next? Of course, we're going to subtract all the costs from the sales revenue.

But there is a bit of structure in an income statement. The first big chunk that is the upper part of
your income statement will be dedicated all the times to what we call the operations. What are the
operations?

The day to day core business. So purchasing food, producing, cooking, selling pizzas, doing
advertising, doing R & D.
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If you do R & D for pizza business, whatever you do, but the core of the business, the heart of the
business. So, first we're going to subtract all the operating costs, operating expenses that from time
to time, we call opex, standing for operating expenses.

What type of opex can you see here? Well, the second line of your income statement will
systematically be the cost of goods sold, from time to time we also call it the cost of sales and two
important principles are at work, when we compute the cost of goods sold.

Third, the matching principle. So, what you recognise in this line cost of goods sold is truly as per
say, let's listen to the words, the cost of the goods we have truly sold. That is the cost of the goods
that we previously included in the upper line of the sales revenue.

And the second principle that is at work is the consistency principle. Here, we do have a bit of
leeway to contribute to the cost of goods sold includes some fixed in direct costs or not, make up
your mind, decide on a principle, but then stick to it throughout the entire company and over the
different periods.

That's the key message the consistency principle gives us. If ever you're able to include only the
variable costs in the cost of goods sold. As we did in the pizza food truck exercise, then you will be
able to compute what we call the variable margin or the margin on the variable costs.

It's interesting, you can compute it as a percentage of the sales revenue and you can also
benchmark it year on year.

See, how does it evolve over time? Of course, this variable margin must be sufficient to cover all the
costs, all the fixed costs that are going to be expensed further down in your income statement.

In the automotive sector, for example, in the early 2000, you could see that, you know selling prices
were moving down very much, raw material costs were going up very much.

Therefore, the verbal margins were completely shrunk and everybody was wondering, well, is this
business going to last long? If variable costs go up so much and prices go down that much, there
will be no room left to generate a sufficient variable margin to cover all the fixed costs to the
expense later on.

So things have evolved and the automotive industry is doing better and better, but it's interesting to
monitor the variable margin. Then what's next. Well, what's next? All the fixed costs from operations.

So, here I gave you an example with fixed production costs, marketing costs, R & D costs. You could
imagine other types of costs, linked to HR, linked to legal and so on and so forth.

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And as far as fixed operating costs are concerned, let's not forget about depreciation. Most of the
times, depreciation is a fixed cost.

And it is a cost that relates to the operations. It is part of your operating expenses because you do
need the property plant and equipment to run your business. So, you must take into account the
cost linked to utilising this property, plant and equipment.

That is the depreciation. So, in the operating part, we start from sales revenue. We subtract all the
operating costs, and then we are done what we call the operating income. Again, let's listen to the
words.

Operating income tells you what it is. It's the profits from the operations as per se, that we also often
call the EBIT. EBIT is an English acronym that stands for earnings before interests and tax.

But operating income tells you probably a little better what it means. By the way, you may see in my
income statement that just above the EBIT, we had another intermediate level of profitability, the
so-called EBITDA.

What is EBITDA? EBITDA stands for earnings before interest, tax, depreciation and amortization. 

Amortization what's that? Well, it's a very, it's a concept that is very close to depreciation, but it
applies to intangible assets.

Don't bother too much, I must say that in some languages like French, you may have heard my
French accent. In French, for example, we only have one word for depreciation and amortization.

So, it's something a little bit subtle that we have in English. Why do we compute the EBITDA? Why is
EBITDA so important? I would say for two reasons.

The first one is assume you wants to benchmark the performance of two companies. One running
very old equipment, almost fully depreciated, and one running brand new equipment with huge
amounts of depreciation.

Well, of course the company running brand new equipment is likely to have a lower EBIT than the
one running fully depreciated old equipment. But does that mean that running old the equipment is
better?

Well, not necessarily. It may create more problems to come in the future and these very old
equipment will suddenly have to be renewed in the future.

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So, temporarily we have very low depreciation one. But don't worry, depreciation is going to come
back very quickly with high on numbers in that company.

So, it's only something very temporary that you can see a fairly high operating income in that first
company running all the equipment. So, benchmarking companies against the EBITDA, before the
depreciation expenses allows us to get rid of this bias, linked to the age of the equipment.

Because if I look at the EBITDA, I'm just before the depreciation expenses. The second reason why
EBITDA is so closely looked at nowadays is that it's because EBITDA closely relates to the
generation of cash at operating level.

If you look at all the lines that are involved in the computation of EBITDA from sales revenue down
to research and development in my example, here, you will realise that all these lines are 100
percent cash in or outflows.

Maybe not a 100 percent this period. Maybe some customers have not finished to pay us yet.
Maybe we've not finished to pay our bills to our different suppliers. But sooner or later, all these
lines will translate into cash.

Whereas depreciation will never, ever translate into cash. So, if you're interested in how much cash
was generated by the operations during the period, it's a much better idea to start from EBITDA
than EBIT.

Then, you will have to make some adjustments because profit is not cash, you saw that in the pizza
exercise. So, you will have to make some adjustments and we will see that when we look at the
cashflow statement in greater details in an upcoming module.

Speaker: Marie-Lys Leschiera

So, this is the first part of your income statement. The upper part of an income statement always
speaks about the operations and the operating part systematically finishes with the operating
income.

That is the most comprehensive measure of the profits made by the operations. Here, we made
$3,600, for example, of operating income.

I don't know if it's a lot or not a lot. Usually you don't speak in dollars, but you speak in percentage
and you compute the operating income as a percentage of your sales revenue.
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And you say that's your operating income was 5 percent here in my case, or you say the operating
margin was 5 percent. Operating income as a percentage of the sales revenue is often called the
operating margin.

We'll go deeper in the analysis in the next module. These operating margin, of course you know, it's
very interesting to look at how it evolves over time. From a year to the next and also benchmark it
against competition.

I invite you to have a look at companies you're interested in.

Please go to the web and look at that corporate website, go through the investor relations section
and you should be able to locate that annual report or a summary of the key numbers, and you
should be able to compute very quickly their operating margin and benchmark it against
competition. A

nd see how it evolved over the last 2, 3, 5 years.

It's a very interesting exercise and fun exercise to do. Then we need to speak a bits about the lower
part of the income statement. So what do we have next? Well, we're left with expensing two
different categories of costs.

First we have a finance section, so we need to look at the financial results. So, we're going to
subtract the interest expenses, linked to the loans we've previously borrowed from that.

And maybe we had invested in a couple of financial securities, for example. So we're going to have
an interest income on those financial securities.

It isn't present in my example, but that could happen real life. So, we have a financial result to take
into account. Lastly, interest income minus the interest expense.

And that will take us down to the earnings before tax. The earnings before tax is an important level
of profitability because that serves as a basis to compute the income taxes due to the government.

And therefore we'll be able to expense the taxes next. So, taxes will be computed as a percentage
of the earnings before tax.

And after subtracting the taxes, you realise that we've paid everybody that was involved in running
the business this period.

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So, we're done the net income or earnings after tax. You can call it one way or another and this is
the level of profits that goes back to shareholders.

See above the net result, we had paid everybody involved in business, the suppliers, the workforce,
the consultants, the banks, interest expenses, the government to taxes.

So, done the net income, only the shareholders are left to pay. So, net income is the one that is
going to be taken to the owner's equity in the balance sheet of the company.

Speaker: Marie-Lys Leschiera

I think we should also do a wrap-up of the learning acquired so far regarding balance sheets. So,
what is a balance sheet?

A balance sheet, we said, is a snapshot of a company's situation taken at one point in time, maybe
on December 31st or on March 31st, at the end of the fiscal year. A balance sheet has two sides:
assets versus liabilities and equity.

Assets represents what the company owns, liabilities and equity represents what the company
owes to external parties. Equity is owed to shareholders, liabilities to other parties, so technically
this is: where does the money come from and how it is utilised, invested.

And by definition, the total of the assets must match the total of the liabilities and equity. Whatever a
company owns, it owes it to external parties. Let's do a quick review of the main items that enter the
assets and the liabilities and equity.

As far as assets are concerned, you can see a big chunk which relates here to property, plant and
equipment. Actually, it's part of a bigger category that we usually call fixed assets. As far as fixed
assets are concerned, you can have property, plant and equipment.

These are tangible fixed assets. You could also think about intangible fixed assets, and you could
also think about financial assets when companies hold shares in other companies. Besides the fixed
assets, mainly the property, plant and equipment.

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Usually what do we have? We have inventories. Inventories, this is the valuation of the goods
stored, kept in the company to be sold or utilised for production purpose a little later. Of course, you
have different categories of inventories.

You have raw material inventories, you have finished goods inventories and you have
work-in-progress inventories. These are goods in the process of being transformed into finished
goods.

Depending on the type of product you're dealing with, you will hold more or less work-in-progress.
If your production process is very long, you will hold work-in-progress for long periods of time and
the majority of your inventories will be work-in-progress.

Companies try to limit the finished goods inventories they hold, but sometimes they still hold huge
inventories because, by definition that production process requires they always hold a big amount
of work in progress.

A key principle when we value inventories is to be prudent. Remember, the prudence principle we
already discussed. This prudence principle states that assets should not be overvalued and
liabilities should not be undervalued, in particular that applies to inventories.

Let's not overstate the value of our inventories. So, recognise the value of inventories at the lowest
value possible between the purchasing price, okay and the possible market value that can be
estimated.

Next to inventories, we can see, accounts receivable, so accounts receivable represents the
fraction of the sales revenue that we have not cashed in yet. This is how much money customers
still owe us and, lastly, you can see cash.

Cash is how much cash do we have on the bank account of the company or in on in its wallet at the
end of the period here at the end of the year.

This number comes straight from the cash flow statement, and you remember this link, we saw a
couple of times in the pizza exercise between the cash flow statement and the balance sheets.

That's for the main items on the asset side. On the liability side, we have two categories of items. If I
start at the bottom, I have all the liabilities.

So, accounts payable, this is how much cash we still owe to our suppliers, because we've not
finished to pay our bills. Then we have long-term and short-term debt.

This is the money we owe to banks. What's the difference between long-term and short-term debt?

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Well, financially speaking in accounting, we consider assets to be or liabilities to be short-term when
their maturity is less than one year. Anything with a longer maturity than a year is considered long
term.

So, here you can see that you know I will have to repay 2,600 of debt within the next year, because
it is short-term debt.

So, it's important to see how much of the debt is going to expire short term and maybe needs to be
renewed.

Okay and how much is more long term is going to stay there for a longer period of time will not
need any renewal for more than a year and will not necessitate any cash outflow over the next year.

That's the first category. The second category is owner's equity, so owner's equity represents all the
money that belongs to shareholders in the company.

This is composed of the initial share capital invested plus maybe additional share capital issued
during the life of the company.

Okay, and they are valued here at their issue price. Then we have the retained earnings, so
accumulated profits and losses since the creation of the company and not yet distributed in
dividends and, lastly, the net income of the year.

You have one balance sheet on screen here and it's pretty difficult to interpret anything from the
performance of the company during the year looking only at one balance sheet.

You seldom have access to only one balance sheet.

What is a lot more interesting is to be able to see two subsequent balance sheets, end of last year
end of this year, and then we can see the evolutions and we can find entry points to challenge the
performance achieved.

Speaker: Marie-Lys Leschiera

I also want to come back to the retained earnings. Some of you may, you know, feel like, yeah, but
how do we distribute dividends?

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We say dividends will be taken out of retained earnings, but how does that come into play?

So, here I'm putting on screen, two subsequent balance sheets of a fictitious company, and I'm
claiming that this company did distributes dividends during year end.

Can you guess why? So, actually I know that this company did distribute dividends during year end.
If I compare evolution of retained earnings from last year, this year, look at the end of year and
minus one.

The total of the retained earnings were amounting to 1,400 and last year the company made a profit
of 400.

So, if no dividend was distributed, then the retained earnings at the end of year end must be 1,800.
Previous retained earnings plus profit of last year.

But it's not the case. End of year end, the retained earnings are only 1,600, so 200 are missing.
Where are they? Cash cannot disappear. Retained earnings cannot disappear.

If 200 of retained earnings are missing, it means that 200 of dividends were distributed during year
end.

Therefore, my retained earnings only increased by $200 instead of 400. So, dividends make the
retained earnings account decrease on the balance sheet.

And of course on the other side of the balance sheet, dividends also make the cash decrease by
the same amount. And that way my balance sheet stays balanced.

Speaker: Marie-Lys Leschiera

I hope you also better realise the links that exist between these three statements and the fact that
the cashflow statement bottom line feeds the assets side of the balance sheet. Whereas the income
statement bottom line feeds the liability side of the balance sheet.

And as our balance sheet is always balanced, actually the three financial statements are always list
together like the three angles of a triangle.

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We often speak about the financial triangle. And definitely, I hope you are convinced that if we want
to have a comprehensive view of what happened in a company during a period of time, we need to
look at the three statements.

It's not enough to look at the income statement. We have key information embedded in the
cashflow statement and the balance sheet.

And also the other way around when we are managing a company, we can't manage only against
the income statements. You will come to look for profits only.

You need to pay attention to cash as well. You need to be aware of the resources you're employing
in the balance sheet to run your business.

So really, you know good Managers top performing Managers will be the ones that are able to take
into account the impact of the decisions on the three statements at the same time.

Speaker: Marie-Lys Leschiera

I order to wrap up what we've seen so far regarding how does a business work? I like to show with
you this short framework, if you, I we're about to start our businesses tomorrow.

Where would we start from, from a finance perspective? I bet we would start by raising funds. Who
would we raise funds from? Actually shareholders and bankers.

Maybe we will be the shareholders of our own companies. Maybe not. So, shareholders and
bankers, these are the fund holders of the company.

Once we do have that many, what do we do with it? Well, of course we invest it. Invest it in what?
Invest it into assets that are necessary to run the operations, to run the day-to-day business,
machines, inventories, and so on and so forth.

Once these assets are in place, what do we do? Well, of course, we start to run the operations and
hopefully, we are able to make a profit from the operations.

This is the so-called operating profits or operating income or EBIT. Then who has a claim on that
profit, on that operating profit. First, we will have to pay the interest expenses due to the banks
because we previously borrowed money from them.

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Second, we'll have to pay taxes to the government. And third.

If anything is left, it belongs to shareholders, who will be free to decide either to distribute
dividends, to get the liquid reward on their investment, or to leave the profits inside the company.

In that case, the earnings will be retained inside the business and available to grow it in the future.

That is to purchase more assets to run the operations, grow the sales, and hopefully grow the
profits next year and so on and so forth.

So, you realise probably that's the Northwest corner is pretty well described by the balance sheet.
Though, it would probably need some tweaks then the lower part and the right parts are showed by
the income statements.

And the cash flow statement. Well, the cash flow statement is everywhere in the framework.

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