Crash Course in Accounting and Financial Statement Analysis, Second Edition

Introduction

RECALL THE STRUCTURE of the income statement: The final measure of profitability after the deduction of all expenses is net income.

Net income is an extremely useful metric in financial analysis; it reflects ongoing profitability. However, since the income statement measures profitability using accrual accounting, it suffers from the limitation of not being able to objectively tell us what is happening to cash during the year.

The Lemonade Stand—Revisited You purchased a lemon squeezer and a lemonade stand for $30 and estimated that both of these fixed assets will have a useful life of three years, by the end of which they will be obsolete and be thrown away. It is important to recall that even though you paid cash upfront for the entire cost of the machine, you did not expense the entire $30 cost on the income statement. Instead, you estimated a useful life of the squeezer for generating lemonade (i.e., revenues for your business) to be three years, and so you spread the depreciation expense (at $10 per year) over this period in order to match revenues and expenses, as required by the accrual accounting. January 1, 2007 to December 31, 2007 Income Statement Revenues 100 – Cost of Goods Sold 20 – SG&A 15 – D&A 10 EBIT 55 – Interest Expense 5 – Taxes 20 Net Income 30

Year 1 D&A expense was $10 (as shown on the right) Actual cash expense was $30 Year 2 D&A expense is $10 Cash expense is $0–you already paid for the machine in year 1 Year 3 D&A expense is $10 Cash expense is $0   Year ...