FINC 3015 Financial

Valuations

Dr Craig Mellare
S1, 2021

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Topic 2C The Income
Statement

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 Income Statement
– The Income Statement measures the net economic benefits generated over
a period of time.
– It uses the principles of recognition developed for assets and liabilities.

– Given the clean surplus relation, what information does the income
statement add?
– The information comes from the classification of changes in assets and liabilities into the
components of income.

– This statement does not give full information about the amount of cash
that the firm generates.
– It aims to provide a measure of the economic performance of the firm.

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 Income Statement
Cost of making the Revenue/Sales (1)
product Other Income (2)
Total Revenues (3=1+2)
Cost of Goods Sold (COGS/OPEX/Cost of Sales) (4)
Selling, General and Administrative Expenses (SG&A) (5)
Earnings before Interest, Taxes, Depreciation and Amortisation (6=3-4-5)
Supporting the
business
(EBITDA)
(product/service) Depreciation (7)
EBIT (Earnings before Interest and Taxes /Operating Profit) (8=6-7)
Interest (11=9+10)
Interest Expense (9)
Cost of financing Interest Income (10)
EBT (Earnings Before Tax/ Income Before Taxes) (12=8-11)
Taxes (13)
Taking care of the tax-
Net Income (14=12-13)
man

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 Income Statement (Example: Telstra)

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 Revenue
– Revenue is defined to be an increase in assets or reduction in liabilities that is caused by the
sale of goods and services as part of the firm’s normal operations.

– The general rule is that revenue is recognised when:

– The earnings process is substantially complete; and
– Collection is reasonably assured.

– This is straightforward for most cases, but can require subjective judgments in certain cases
such as long-term contracts.

– Revenue is the key driver of the firm’s activities, once revenue is recognised accounting rules
attempt to match asset consumption necessary to produce the revenue.

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 Getting the Basics Right – Revenue Recognition

– Revenue recognition criteria is even more important than you may first appreciate –
why?
– Companies are valued on multiples of revenue (Therefore, higher revenue  higher
value)
– Pro-formas are typically prepared in a top-down fashion – hence revenues are a key
driver of profits.
– Revenue quality – and the ability to turn it into cash – will tell you a lot about the
financial viability of a firm.

– Remember, that an income statement does not necessarily tell you about cash!
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 Expenses
– Expenses are the opposite of revenues; they are the decrease in assets or
increase in liabilities that arise from the normal operating activities of the
firm.
– The objective is to match consumption of assets to the revenue produced.
– Making/Buying the Product = COGS/Gross Profit

– Supporting the Business = SGA / Operating Profit

– Financing the Business = Interest & Finance Costs / Profit Before Tax

– Paying the Government = Tax Cost / Profit After Tax (NPAT)

– Frequently there is an arbitrary allocation of costs over the useful life of an

asset such as straight line depreciation.
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 Profit
– There are many “profit” or “earnings” numbers analysed.

– Operating profit or EBIT is the difference between revenue and expenses associated
with the firm’s recurring or ongoing operations. This is seen as the primary driver
of firm value (also note the use of EBITDA).
Operating Profit (EBIT) =Revenue – Expenses

– Profit Before Taxes (PBT) or EBT accounts for the firm’s net interest expense

– Tax is applied to EBT to arrive at Net Profit After Tax (NPAT) or Net Income

– Historical profit numbers are usually analysed excluding or “normalising” for non-
recurring items but are often disclosed in financial reports.

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 Normalised Profit
– Normalised profit removes one-off charges that affect current
earnings.
– These one-off’s are charges not expected to occur in the future.
– They can include: restructuring charges, large gains and losses on the
sale of businesses or assets, impairments of non-current assets, large
one-time tax charges.

– Normalised profits tell us about the profitability of the core

business
– By normalised, they should be core, continuing, and controlled.

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 A note on Depreciation
– In financial statements, the depreciation expense may be included in
COGS or SG&A.

– When analysing a business it is better to separate the depreciation

expenses. Why?

– Depreciation is not a cash expense.

– However, it does generate a tax saving (tax shield) because it is tax deductible
so we need to track it separately in order to accurately calculate cash taxes for
our FCF calculation.

– Best place to get D&A is CFS

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 The End

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