The Income Statement

An income statement summarizes an enterprise's revenues and expenses over a specified accounting period. Months, quarters, and years are commonly used as reporting periods. As with the balance sheet, the heading of an income statement gives the name of the enterprise and the reporting period. The income statement first lists revenues, by type, followed by expenses. Expenses are then subtracted from revenues to give income (or profit) before taxes. Income taxes are then deducted to obtain net income. See Close-Up 6.3 for a measure used for operating profit.

The income statement summarizes the revenues and expenses of a business over a period of time. However, it does not directly give information about the generation of cash. For this reason, it may be useful to augment the income statement with a statement of changes in financial position (also called a cash flow statement, a statement of sources and uses of funds, or a funds statement), which shows the amounts of cash generated by a company's operation and by other sources, and the amounts of cash used for investments and other non-operating disbursements.

CLOSE-UP 6.3 Earnings Before Interest and Income Tax (EBIT)

Income before taxes and before interest payments, that is, total revenue minus operating expenses (all expenses except for income tax and interest), is commonly referred to as the earnings before interest and taxes (EBIT). EBIT measures the company's operating profit, which results from making sales and controlling operating expenses. Due to its focus on operating profit, EBIT is often used to judge whether there is enough profit to recoup the cost of capital (see Appendix 4A).


The income statement for the Major Electric Company for the year ended November 30, 2010, is shown in Table 6.3.

We see that Major Electric's largest source of revenue was the sale of goods. The firm also earned revenue from the sale of management services to other companies. The largest

CHAPTER 6 Depreciation and Financial Accounting investments the proceeds of which have been reinvested in the business (i.e., not paid out as dividends). Firms retain earnings mainly to expand operations through the purchase of additional assets. Contrary to what one may think, retained earnings do not represent cash. They may be invested in assets such as equipment and inventor)7.

The balance sheet gets its name from the idea that the total assets are equal in value to or balanced by the sum of the total liabilities and the owners' equity7. A simple way of thinking about it is that the capital used to buy each asset has to come from debt (liabilities) and/or equity (owners' equity). At a company's start-up, the original shareholders may provide capital in the form of equity7, and there will also likely be debt capital. The general term used to describe the markets in which short or long-term debt and equitv are exchanged is the financial market. The capital provided through a financial market finances the assets and working capital for production. As the company undertakes its business activities, it will make or lose money. As it does so, assets will rise or fall, and equity and/or debt will rise or fall correspondingly. For example, if the company makes a profit, the profits will either pay off debts, be invested in new assets, or be paid as dividends to shareholders. Figure 6.4 provides an overview of the sources and uses of capital in an organization.•

Figure 6.4 Cash Flow Relationship Between the Company's Assets and the Financial Markets

Financial markets provide capital: e.g., short- and long-term debt, shares.

Financial markets provide capital: e.g., short- and long-term debt, shares.

Repayment of debt

Capital for investment

Firm invests capital in productive assets.

Profits are used to pay taxes, dividends to shareholders.

Profits may also be reinvested into the firm.

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