Reading: Accounting Framework

The income statement measures the company's financial performance over a specific accounting period (typically 1 year). The basic structure of the income statement is as follows:

The key elements of the income statements are defined as follows:

• Net revenues (sales): Total sales during an accounting period (net of returns, discounts, and allowances)
• Costs of goods sold (COGS): All direct costs related to the products and services sold during an accounting period (e.g., purchase of material, labor costs related to the production). Importantly, for manufacturing firms, the COGS typically also include the depreciation and amortization charges on the non-current assets that are used for the products and services sold.
• Selling, general, and administrative expenses (SG&A): The combined cost of operating the company (e.g., salaries not directly related to production, advertising, rent, executive salaries, depreciation on assets that are not directly used for the products and services sold).
• Other revenues & expenses: All non-operating revenues and expenses such as interest earnd on investments or interest paid on debt. 
• Income taxes: Provision for income taxes.

The two most important earnings figures that we can directly read from the income statement are EBIT and net income:

• Operating profit or Earnings Before Interest and Taxes (EBIT): A measure of the firm's operating profitability. It shows the firm's earning power from ongoing operations.
• Net income: Reflects the total revenue minus all expenses during an accounting period. Ultimately, net income shows the amount of money that a firm generates for its shareholders during an accounting period.

A third earnings that is closely related to EBIT is the firm's EBITDA, the Earnings Before Interest, Taxes, Depreciation, and Amortization. We find EBITDA by adding the firm's depreciation and amortization charges to EBIT. Most definitions of EBITDA also add back any impairment charges to non-current assets as they are essentially equivalent to depreciation. Therefore, we find EBITDA as follows:

Depending on the accounting standards, the various charges are either reported directly in the income statement or in the footnotes to the income statement.

Because this profitability measure is before depreciation (amortization and impairment), it is less affected by accounting choices concerning the firm's depreciation policy. Therefore, it can be a useful measure to compare the profitability of firms that operate in capital intense industries. 

Finally, the fourth earnings figure that we fairly often use in financial management, and which is also not directly visible in the income statement, is the so-called Net Operating Profit Less Adjusted Taxes (NOPLAT). 

NOPLAT tries to identify the firm's net income that is attributable to its operating activity, free of financing effects. Starting point for the computation of NOPLAT generally is the firm's EBIT which, as we just have seen, shows the firms earnings before interest and taxes. All we have to do to get from EBIT to NOPLAT is to subtract the taxes the firm would pay if EBIT constituted the firms pre-tax income:

As an example, consider the income statement of The Hershey Company, as reported in their SEC filings for the business year 2015 (Worksheet "Consolidated Statements of Inco"). Values are in thousands of USD:

This income statement follows the exact same logic as the template shown above, though the names of the various items might be slightly different:

• First, all operating expenses are subtracted from net sales to obtain the operating profit (EBIT)
• Then, the income statement considers all income and expenses that are not directly related to the firm's operating activity. In particular, interest expenses.
• Finally, provisions for income taxes are recorded to obtain net income.

Now let's also try to estimate Hershey's EBITDA and NOPLAT. 

EBITDA:

• The firm's EBIT is reported in the income statement ("Operating Profit"). It was 1'037.8 million in 2015.
• In the income statement, we also see impairment charges of 280.8 million.
• But what about depreciation and amortization? As we have mentioned above, depreciation and amortization charges are subsumed in the cost of sales and the SG&A expenses. The footnotes to the annual report provide the necessary details. In the case of Hershey, the total depreciation and amortization amounted to 244.9 million.
• Consequently, we can write:
   
  EBITDA = EBIT + Depreciation and Amortization + Impairment of Non-Current Assets = 1'037.8 + 244.9 + 280.8 = 1'563.5 million.

• The firm generated an EBITDA of 1'563.5 million in 2015. This is the firm's profit before investment and financing effects, and before taxes.

NOPLAT

• Given an income before taxes of 901.8 million and a tax burden of 388.9 million, the firm's average tax rate is approximately:
   
  Average tax rate = \( \frac{\text{Provision for income taxes}}{\text{Income before taxes}} = \frac{388.9}{901.8} \) = 43.1%.
    

• Consequently, the firm's NOPLAT was approximately: