what most people focus the most on when they analyze

companies, and that's the income statement.

And the income statement is one of the three financial

statements that you'll look at when you look at a company.

There's the income statement and the other two are the

balance sheet, which I have drawn a lot in a lot of the

other explanations I've done on the financial crisis and

whatever else.

And actually, in this video, we're going to see how the

income statement relates to the balance sheet.

And, of course, the last one-- well, it's not of course if

you don't know it-- is the cash flow statement.

And we'll focus on that a little bit later because

that's a little bit more nuanced relative

to the income statement.

So the income statement is literally just saying how much

a company might earn in a given period, and it's always

related to a period.

So it could be an annual income statement.

It could be for the year 2008.

It could be a quarterly income statement.

Those are usually the two types that you see, but

sometimes, there's monthly or six-month income statements.

And the general format is pretty consistent, although

there is a lot of variation depending on what a business

does, but in this video, I really just want to cover

almost a plain vanilla income statement for a company that

just sells a widget.

So the first thing when you sell a widget is you make it

and you just sell it.

You sell the widget.

You give a customer a widget, and they give you some money.

And that money that they give you-- and I'm not going to get

too technical about the accounting right now-- is

considered revenue.

It's sometimes considered sales.

And that's literally the money that they give you at a

certain period of time.

And some of you accountants out there are like, oh, well,

no, that's not just the money that they give you.

It's the money that you've earned in a certain period of

time, and that's true.

But for our sake, let's just say that when you give the

widget, you have earned the money that they give you, and

that's revenue sales.

Later on, we'll talk about different ways to account

revenue and sales.

So let's say the revenue or the sales in this case in a

given period, let's say that this is an income

statement for 2008.

So over 2008, we sold let's say $3

million worth of widgets.

So let's say it's $3 million.

And a lot of times when you look at income statements for

companies, if you go to Yahoo!

Finance, you could do this right now, instead of writing

$3 million, you'll see $3,000 there.

It's like, oh, my God!

This company, they're hardly selling anything.

But it's kind of a standard that they tend to write things

in thousands.

So 3,000 would be 3,000 thousands,

which would be 3 million.

And for really big companies, they actually sometimes write

their numbers in millions.

So if you saw 3,000 there, it would actually mean 3 billion.

But we'll actually look at real income statements in the

not-too-far-off future.

So that's how much money they give us.

But that's not how much income we made, because there was a

lot of cost that went into making that widget that we

have to account for.

It's not like when someone gives me $3 million, I can

just say, oh, I made $3 million.

Let me just put it all in the bank.

I'm done.

That was all income.

So the first thing that you tend to see on an income

statement is the cost of those actual widgets, the cost of

producing those widgets.

And I'll put all my expenses in magenta.

So it'll sometimes be written as cost of sales or cost of

goods sold.

And this is literally-- well, there's two things.

There's a variable cost which is, each widget, they might

have used some amount of metal and some amount of energy to

produce it and some amount of paint if

it's a painted widget.

And so that the cost of goods is literally how much did it

cost to buy the metal and the paint and provide the

electricity to make those $3 million worth of widgets.

That's the variable cost. And then on top of that you have

the fixed costs, or the relatively fixed costs, where

just to have the factory open, it costs a certain amount of

money every year, regardless of how many widgets you make.

And we'll go into more detail on that, But for simplicity,

let's say all those costs of making the

widgets were $1 million.

So sometimes someone might say it's a $1 million cost. When I

make models, I like to put a minus there, so that I

remember that that's a cost. Anything that detracts from

income I put as a minus.

Anything that adds is a plus, although that's not

necessarily the standard convention.

Some people say, oh, it's a positive $1 million cost,

which means you subtract.

But either way I think you get the point.

And then if you subtract your costs from your revenue, or if

you just add these two numbers, because this one is

negative, you have your gross profit.

And in this case, it would be $2 million.

And this number tells you, how much money did you make, or

how much profit did you make just from

selling these widgets?

So the more widgets you sell, in most circumstances, the

larger this number is going to be.

So this is your profit before all of the other expenses that

a company has to incur, like the taxes

and the CEO's salary.

The CEO's salary doesn't go in here, right?

Because the CEO doesn't go out there to the factory in most

cases and actually help make the widget.

So the CEO's salary or the CFO's salary or the

headquarters in a nice skyscraper, that doesn't get

factored in here.

Or the marketing expense, right?

You have to tell people, hey, we make good widgets.

So none of that is factored in here.

So that goes into the next line.

And oftentimes, you'll see it broken up, where they'll have

marketing expense.

Sometimes you have to pay salespeople, so you might have

sales expense, and then the stuff like the corporate

office and the CEO's salary, and you have to hire auditors

and accountants and all of that.

That might be included as general.

Actually, I should be doing this in magenta because it's

all expenses.

Marketing, sales, and then G&A you'll sometimes see.

Sometimes you'll see SG&A.

G&A just stands for general and administrative expenses.

If you see SG&A-- sometimes instead of that you'll see

SG&A-- that mean selling, general and

administrative expenses.

Selling is things like, it could be the commissions that

the salespeople get.

It could be just the cost of having salespeople travel

around the country and taking people out to steak dinners.

And then the general and administrative, that's just

all the stuff that the corporate office does, and all

the people who are at that level.

So if you subtract these, and I'm just making up these

numbers as I go.

Say, in marketing, the company is spending $500,000.

And I'm putting it as a minus because I like to remember

it's an expense.

Some models you'll see, they'll say

it's $500,000 expense.

Sales, let's say, this is just G&A here.

I want to make a separate line for sales.

So let's say sales, selling expenses is $200,000.

And let's say G&A, the corporate offices and all of

that, let's see that's another $300,000.

And now we're ready to figure out how much money did the

operations of this business make?

So this is operating profit.

This is really important to pay attention to, because so

many people say, oh, a company made this much.

And you'll hear these numbers, gross and operating profit and

net profit and pretax profit, and it's very hard to

understand that these are actually very, very different

things, because they all have the word "profit," and what

does gross and operating and all that mean?

But here you see it means very, very different things.

Let's calculate this number first before I go off on one

of my tangents on all the differences between the

operating and the gross profit.

But let's see, 2 million minus 1 million.

My head I think implicitly made the

numbers work out nicely.

So my operating profit here is $1 million.

So already we have some new nuance on profit.

I made $2 million just from actual widget sales, but then

when you take out all of the overhead of the company, the

marketing, the sales, the general and administrative

expenses, I'm only left with $1 million.

And this is the profit from the operations of the company,

or you could say from the assets or from the business or

from the enterprise of the company.

That's what it is generating.

But we can see-- I've drawn a bunch of balance sheets before

and I think this is a good time to draw a balance sheet.

So you have kind of the assets of a company.

And we'll talk a little bit more about assets and

enterprise value, and there's a little bit of a nuance

there, but essentially the company itself.

Before you think about how the company is paid for or how

it's funded, if you just think about the enterprise itself,

the assets.

The assets are generating this.

They're generating the operating profit, and that's a

very important thing to realize in the future when we

talk about return on assets.

Actually, we could talk about it now.

Let's say our assets, if we paid $10 million for these

assets, and these assets-- this is the income statement

for 2008-- are spitting out $1 million a year, or at least $1

million in this year, our return on asset-- I wasn't

planning on introducing this, but it doesn't hurt to

introduce it right now-- our return on asset, often

acronymed ROA, would be-- well, the numerator is the

return, which is $1 million.

The denominator is the assets, $10 million.

So we got a 10% return on our assets.

For a $10 million investment, we're getting

$1 million a year.

We're getting 10% of our asset investment back every year.

So that's a nice thing to keep in the back of your mind, this

return on asset concept, and it's very closely tied to

operating profits and the actual assets of a firm.

What we've learned, and especially if you watched some

of my other economics videos, that all companies aren't

financed the same.

A lot of them might have some debt.

So let's say that company had $10 million of assets, but

let's say they paid for it with $5 million of debt.

And let's say the interest rate on that debt is-- let me

think of a good number-- 5%.

Let's make it easier.

Let's make it 10% interest.

So this is the operating profit.

This is the money that just comes out of the asset itself.

But, of course, that's not the money that we get to take

home, because we have to pay this interest. So let's throw

that in there as an expense.

Interest expense.

And obviously, a company that has no debt will have no

interest expense, but in this case, we do.

And this is an annual income statement.