How to Read a Financial Report: Wringing Vital Signs Out of the Numbers, 8th Edition

CHAPTER 4

PROFIT ISN’T EVERYTHING

Threefold Financial Task of Business Managers

In Chapter 2 we introduce the three primary financial statements for a representative business example—the income statement, the balance sheet, and the statement of cash flows. We start this chapter by calling your attention to stockholders’ equity in the balance sheet. Its owners have invested $8,125,000 capital in the business for which it issued capital stock shares to them. See the capital stock account in Exhibit 2.1. Furthermore, over the years the business has retained $15,000,000 profit, which is called retained earnings. Taken together these two sources of owners’ equity equal $23,125,000. One purpose of the balance sheet is to disclose such information about the ownership of the business entity and the sources of its equity capital.

The stockholders expect the managers of the business to earn a reasonable annual profit on their $23,125,000 equity in the business. In its most recent annual income statement the business reports $2,642,000 bottom-line profit, or net income. Profit equals 11 percent on the company’s year-end stockholders’ equity. The stockholders, as well as the company’s managers and its lenders, want to know more than just bottom-line profit. They want to see the whole picture of how profit is earned. Therefore, the income statement reports totals for revenue and expenses for the period as well as bottom-line net income.

The ability of managers to make sales and to control expenses, ...