So, uh, my name is Chris Cordone. Uh, I'm an instructor for Financial Edge.

I'm very happy to be here part of this series, and I'm looking forward to spending the next, I guess we've got about 10 sessions. Um, not that, um, I, I, I think they're op optional in a sense that, you know, if as long as you are a a Felix, uh, registrant, you can, you can join these. But, but we've got 10 kind of on the docket, and today's the first one, which is going to be on income statement, uh, analysis. And, uh, we're gonna spend two hours taking a look at that.

My, um, you know, my, my style of teaching, I, I'm a former investment banking analyst and associate, so I, I've been in the trenches and I, I kind of know, uh, that, that feeling, I have that perspective of having worked on, on transactions, on deals.

I think I, if I have anything, it's that, you know, it's, um, uh, that was a while ago. But, um, but I, I like to, if anything, bring context to the stuff that I talk about. Uh, there are many, many more people who know the accounting better, that know the Excel better, that know, you know, the academics behind, you know, the, the D C F better. There's plenty people out there that, that, that are smarter than me. But, um, one of the things I think that I've been able to do in my, you know, now very long time teaching is, again, try to tie this back into, you know, what you look at when you, when you actually, uh, have to start working on a project, on a transaction, or on a pitch, on a model, whatever, it's, so my style of teaching is we're going to, um, uh, in this format, it's gonna be a lot of me talking. Unfortunately, we've got a q and a, uh, uh, option here for you to interrupt at any time with a question.

I will answer that question probably, probably vocally, uh, as opposed to, uh, typing. I'm, I'm a horrible typer, so I've got, gotta admit that right off the bat, had a hard time keeping up with the chat in the, in the good old days of chat, uh, in know chats on Zoom. Um, but I encourage you to do that. And I like to teach combination of, you know, I, I, I use, uh, Excel, I use whiteboards.

I don't do a lot of PowerPoint flipping 'cause it's just not, it's not my style.

Uh, although I, I, I, occasionally I will do that, depends on what we have.

So the first thing we need to do is make sure that everyone has access to the material and quickly go over to Felix. Um, and we've got the two sides to it, the learning, which is where all the, you know, kind of our courses are. And then, um, we've also got the, um, we've also got the analyze, which is where we can look up company data, right? So that's where, you know, I'm going to, uh, I'm gonna spend some time going into different, different companies, different, different resources, um, that we can look at and see, you know, kinda where everything is. Hang on one second. I just got, uh, something pop up on my screen. Okay, great. So, um, for right now, I don't need any of that. I'm just going to, um, kind of kick this off, you know, just to have a, a quick little kind of catch, uh, uh, catch up as to, you know, how I'm gonna approach this discussion of the income statement. You know, we've got a couple of hours here, I wanna make sure we use it. You know, right now, as I said, this is sort of a newish kind of format here.

And essentially, you know, what we have is, you know, kind of enough time that, um, you know, we can cover this, this material, uh, I think in a pretty detailed way. However, two hours is usually a little bit longer than I like to just kind of talk, you know, in that sense. So, um, I'm gonna try to structure it so that when we get to about the hour mark, I'm gonna give you a problem to work on.

Now that may not be exactly at the hour, it may be a little bit before, a little bit after, but it'll break up this two hours a tiny little bit in case you've gotta, you know, um, run and grab a cup of water, whatever you need to do, and just kind of give us a break from that. So, uh, back to, um, you know, where we are with this income statement. So, by the way, I, if I can give you any, any tips about shortcuts and whatnot as I'm working with Excel and PowerPoint and whatnot while I'm here, I, I generally throw those in there. If you noticed, uh, I do a lot of Zoom calls with analysts where I help them sort of, you know, break down their models or solve their models or find mistakes. And I get on, you know, I get on Zoom. And one thing that happens when you get on Zoom is, um, you look, they'll share their screen, and then the majority of their screen, if it's a spreadsheet in particular, is kind of taken up, you know, by this, um, you know, the maj by this, uh, top header, let me just show that here.

You can see this sort of top ribbon takes up a big chunk of the screen.

So if you hit control F one in any of the Microsoft Word, uh, program, uh, mi, Microsoft programs, word, Excel, PowerPoint, I think even, uh, outlook, uh, as well, that ribbon kind of goes away, control F one.

And that just gives you a little bit more of a playing field to work with, which, you know, which I like, because, you know, one, I want you to be able to see what I'm doing. And two, all that stuff is just kind of in the way. So, um, looking ahead a little bit, I always, always say that, you know, we can never be so tunnel vision that we're just looking at what we're doing. We gotta think about how this fits into the scheme of things.

I look at where we're going with this, and I know that working capital's coming up, and I know that cash flow's coming up, and I wanna make sure that I'm teaching this in a way that we're, we're understanding how these pieces fit in, because a week off in between is like, you know, I mean, I don't, I don't remember what I did last week. Um, so, you know, and you, and you're all busy at work as well.

So I wanna try and do my best to kind of, to, to front run some stuff here.

Now, what we've got here was this day on the income statement. The, the income statement obviously is one of the main financial statements, right? We've got, um, we, we've got the balance sheet, which is usually how I begin my sort of tour of financial statement analysis is with the balance sheet.

Because the balance sheet, you know, is that, um, is the thing that really starts it all off. You know, you cannot start a business unless you have a balance sheet because you have to raise capital, and then you've gotta take that capital cash from the capital raise, put the assets in place, and now you've got a business. So, you know, on day one, you have a balance sheet, and you don't necessarily have an income statement until you actually start, you know, selling stuff. So I always start with the balance sheet, but we're not, we're not going to, you know, do much with that today, except, you know, we think about, you know, a balance sheet is obviously assets equal to liabilities and equity.

And you know, what happens when you raise capital, of course, is that you take money from people and then that's their, you know, that's their contribution to the business is that capital. Well, now we have to show them, of course, that we've, you know, that we've actually, that we're doing something with the cash that they've given us.

And that is hopefully generating, you know, profits, cash flows, you know, whatever, you know, however you want to think about it.

So the, you know, initial equity investment is, is going to show up here in equity. And then the, um, the, uh, the way we track this going forward, of course, is we need to figure out what the business is doing in terms of revenues, expenses, profits, so that we can report back to those investors.

So that is done on the income statement. So we've got an income statement here, which is going to track over a period, the revenues and the expenses.

And this is what we're gonna get into a lot of detail with today, but it's important to understand that, that, you know, that net income that we're, that we're getting to here, the reason why this statement exists originally is so that we can attribute this net income back to the people that own shares in the business.

It's theirs. The shareholders of the business own this net income.

So the net income is linked back to the equity section. And that's, you know, that is effectively, you know, what we're trying to get at here.

Now, there's a number, uh, that, that's the first kind of big sort of, you know, broad connection between the financial statements is that that's, uh, that's what's happening now. Uh, we, we obviously, we have another big financial statement over here too, which is called the cash flow statement. And I'm, I'm not forgetting about that, but we're not gonna get to that for a couple, you know, really probably, uh, one session, one plus sessions. So I'll leave that out right now. But, but as we talk about the income statement today, I'm going to, you know, uh, continue to highlight the differences between the income statement, uh, and the balance sheet. Now, one thing we need to know about the balance sheet is that this is a point in time, point in time. So any, any moment you can look at a company's balance sheet and get a, a statement of their financial position.

And it always balances and it always looks lovely. Now, the income statement, on the other hand, well, in theory, if you were to go to an auditor, you know, or, or, or the, the, you know, treasurer or the C F O, they could pull up the, the up to the moment income statement, but it doesn't really tell us that much because, you know, the way companies do business, I mean, it may be seasonal, it may, it may just be kind of an odd, you know, odd point in the year where, or, you know, where stuff hasn't happened, or it may just be after a lot of stuff has happened. So the income statement, we, we don't think of in that way.

The income statement is tracking these earnings over a period of time.

So this is over a period of time.

And that's why when you look at a balance sheet, it says as of a certain date, and when you look at an income statement, it says, for the period, uh, ended.

And if I were to just kind of go over back to Felix quickly, type in, um, you know, I'll just click on Amazon really quickly. If I go to Amazon's, uh, income statement, we can see that it's telling us here for the three months ended, for the six months ended, right? That's telling us what the income statement is. Whereas for the balance sheet, obviously it's saying as of this date, so big, big kind of difference there between those two. And again, feel free to jump in at any point with questions in, in the, uh, in the box.

And, um, I'm keeping an eye on them. And I've also got a, my colleague Darlene is here as well, just keeping an eye on them to, okay, look, there are three things we need to know about the income statement before we kind of even get going on it. There are these principles of the income statement, and the first principle is what we call revenue recognition.

Revenue recognition. And what revenue recognition essentially is, is it sets these kind of rules by which we can actually record a sale.

And what these rules are about all of these rules is that they, they, they're basically designed to keep everybody on the same page for accounting purposes, for financial reporting purposes, or keeping everybody on the same page so that we, so that when we look at financial statements, we know that everyone's played by the same rules. And you might say, well, you know, how, you know, how far off can people really be? Well, obviously, you know, there, there's a lot of, you know, there's a lot of cook in the books out there. And, and even with all these rules, there's still a lot of cook in the books out there.

But what we know is that under, under gap, under, under, uh, I F R S that we have these principles in place.

So what revenue recognition says, and really what, in, in a way, what all of these do is that they kind of take us away from the idea of, of cash. They take us away from the idea that, that there's sort of cash, um, needed to sort of qualify as a transaction.

So revenue recognition basically says is, look, if a, um, service or good has been provided, then a sale is made. A sale is recorded.

So if you think about that, you know, if you go, if you go to a store and buy something easy breezy, right? Because you just, you, you know, you walk in, you pay, you walk out with it, the item, no, you know, no problem, right? Well, um, you know, what happens if you buy something, um, you know, that's, that has to actually, you know, um, be, be made. You know, it's like something that's kind of custom, a custom. If you buy a custom suit, you go to a, um, suit supply or, uh, you know, or one of those places where you can actually go in and get fitted and feel like you're, you know, you're all, um, you know, Superfly and, and, uh, and you know, you've got your custom, um, made to measure suit even, uh, even as you're just beginning, you know, your careers in finance. Um, well, what happens there is that, you know, of course, if, if we, if we think about that transaction, we've, we've, we may have given them some cash. We may have actually given them some money, but we haven't actually received the suit yet. They've gotta make it.

And so from their perspective, they can't record a sale right? Now, we can also think about this in terms of, um, uh, think of an airline. Think of buying an airline ticket. Um, you, you know, you, you look for a flight, you find the flight, you pay for it, they take your cash gone, it's gonna show up on your next credit card bill no matter what.

But from the airlines perspective, again, they have not actually delivered or provided the service, right? Provided the service. Now, I actually used to use that term, delivered a lot when I was teaching, um, has the service or, you know, goods been delivered. But because of now we, because now we buy everything, you know, kind of in the, uh, you know, in that, um, uh, you know, online way of, of just clicking and then, and then having regret later when we see the credit card bill, um, a lot of times the, the delivery aspect of it gets kind of confusing.

'cause typically, when we do buy something that's online, uh, uh, as soon as that retailer puts it in the mail or puts it in the post or puts it out to u p s or at FedEx, they've actually fulfilled their obligation.

Now you've got kind of a third party, uh, situation here that's not, um, you know, that's not actually the, the, um, uh, you know, the retailer's issue.

So that's U P U P S FedEx's issue. So we would count that actually as a sale.

So if the servicer goods has been provided, then a sale has been recorded, this is, uh, regardless of cash. So now by regardless of cash, what I said was, of course, we paid for the airline ticket, right? We paid for the suit. Um, what about when it happens kind of in reverse, meaning that what happens when we don't actually pay for the goods at all? What happens when we get billed later? Uh, you know, think about, um, you know, for example, somebody who's, who's providing, um, uh, maybe toys to, uh, you know, to Walmart or Target wholesale transactions, they, they don't, they don't really cut each other, you know, checks on the spot. You kind of, you kind of do, you know, sort of payment terms.

So if I'm a toy manufacturer and I make a sale to Walmart, uh, as, as soon as I provide the goods, as soon as I put them on a truck and get them to Walmart, that's when the sale is recorded. If it's a third party, it's as soon as if delivering that batch of goods, it's as soon as they're on the truck. If they're my trucks, it might be as soon as I hand them off, uh, at, at the shipping gate and somebody signs the, the bill of goods, um, the, uh, you know, that, uh, that piece of paper that says they received it, done sale has been made. Now, Walmart has not paid me the toy manufacturer for these goods, and they, and they might not pay me for 30 days, 60 days, whatever Walmart kind of feels like, 'cause they're Walmart. Um, although there are generally terms to this stuff.

So what we've got here is this kind of situation where, um, you know, it's not about cash. It's about when the good or the service has been done.

And it's the same thing, by the way, for a service.

If you sign up at the gym for 10 training sessions with your trainer, that trainer in theory cannot recognize all 10 until that trainer, you know, shows up and, and, um, you know, trains you.

So, um, regardless of cash right now, the same thing, by the way, happens with expenses.

So with expenses, we've got a couple of different things going on here.

So we've just sort of established how to record a sale or a revenue, right? And we've separated that from the cash process. Well, expenses kind of work the same. So now, once we have the revenue in place, the accountants say, look, the expenses must match the revenues.

They must match the revenues. So by that, we're talking about the, the ability to say that, that these expenses, which I've incurred are directly related to the selling of these goods.

Now, you might say, well, I mean, yeah, I mean, what, I mean, you know, you're, you're in business, you're, you're generating labor costs, you're generating, you know, materials costs. I mean, like, well, how, how else, you know, how else would you think about it? Except that they're all in pursuit of the sales. Well, um, let's, let's, um, you know, have a think about that toy manufacturer, for example. Um, the toy manufacturer, you know, has to buy raw materials and has to, uh, create an inventory.

And then at the same time, um, we'll have to, um, think about, you know, putting that inventory together and selling it. Well, if it's, if it's acquiring raw materials and putting goods into inventory, those, those goods have not been sold yet.

So the expenses that that manufacturer is incurring to create that inventory is actually not in pursuit of that. The revenue, the revenue is what that toy manufacturer already sold to target. So, um, you know, are, are the, you know, are the, uh, expenses, uh, part of, um, goods or services that have been delivered that have been provided.

If they're not, then they don't go on the income statement.

So where do they go then? Where do they go? And I realize that we don't have an interactive class. So I'm going to, um, be, uh, you know, kind of the, the overactive student here and answer my own, answer, my own questions. I will, I will be that student who always answers all the questions in class.

We've all had them. Um, where do they go? Well, if you think about that for a second, if you create, you know, if you, if you, um, if you are a, a wholesaler, um, uh, manufacturer, for example, and you buy raw materials and you make goods, but you don't sell them, where do those goods go? Well, they go, they're part of your inventory of goods to sell.

So immediately, if we go back kind of to, you know, the, the, uh, you know, the links between the two, what we start to see here is that there are these connections between the income statement and the balance sheet that we didn't even realize were there. Like, we knew that the net income was gonna be part of this, right? 'cause we know that's, that's the equity holders.

But in these kind of handful of examples that I've given, we've got, um, a couple of different connections already between the, um, the, uh, uh, sales and the balance sheet and the, uh, inventory or the goods sold in the balance sheet. Now, Jamila has asked me if I could touch base on deferred revenue.

So this is exactly, uh, what I'm getting to. Um, so if, um, we take a look at the airline example, so I'll put that down.

Let me just, uh, kind of come over back to here.

If I put down here the airline example, what happens with an airline transaction? Well, um, when we make the sale, we have, um, the consumer has given cash to the airline company, the carrier, so to speak.

So I'm gonna look at this only from the airline's perspective, because at the end of the day, I mean, nobody cares about our books, right? As the consumer, that they're, they're our own problems. Um, they care about, we we're, we're trying to get to the corporate side of things here.

So the airline, um, what has happened here? Well, the airline has received cash.

And I'll try to put this, you know, as much in non kind of accounting terms as I can, but sometimes that debits credits kind of sneak out. So forgive me.

So cash goes up, cash goes up. Now what, uh, kind of offsets this, right? What, what, what's happening here? Now, we know that, that Delta or American Airlines is not actually providing a service.

So there's no, there's actually no, no revenue here yet.

What's happening here is that, um, the airline has a promise to provide a service to you.

And that promise to deliver, so to speak or provide, this is an asset, right? Cash goes up that has also been created in this transaction. It's been created.

Now, when you owe someone something, I'm talking about the other side here, right? We're talking about the other side of the balance sheet.

And this is going to be a liability because we owe them a service.

And that service here that we owe them is called a deferred revenue.

And so, in that first example that I, that I gave, we have a situation of a deferred revenue and then cash, right? So the asset goes up, and then, um, then the liability goes up. Now, how do we get rid of this? Well, we have to actually, they have the, the, the, the consumer has to fly.

Once you fly. Now, Delta or American Airlines, whatever, can record that revenue.

And what's gonna happen here is in sort of the second part of the transaction, so this is kind of part A in part B, I hope I don't run outta room here.

I'll, in part B, what'll happen here, there's no more cash. The cash has already been paid for, the flight has been paid for.

So what's actually going to happen here is the, um, deferred revenue is actually going to go down. We're, we're, we're lowering the liability.

So the deferred revenue goes away, and profit is made. Now, I'm not dealing with the cost of flying and what your cost is to fly.

I'm just dealing, I'm pretending right now that there is no cost to us flying.

So we're just looking at revenue as sort of being pure profit. Well, if I drop revenue into the top of my income statement, and it, there's no expenses associated with it, where does it come out? It comes out in net income, effectively, right? So that net income will then get brought back over, as we discussed, to the earning, uh, to the, uh, equity section or the retained earning section.

And therefore, that revenue on that transaction increases my, my equity, my retained earnings by that amount. Now, in the airlines, it's a little tricky, right? 'cause you only fly half, you do half of the trip, right? If you bought a full round trip ticket. So we'd be, we'd be, we'd be actually writing off half of the deferred revenue and recording half of the ticket price. But let's just pretend it's a one-way ticket to, uh, to Fiji. And we're done, we're done with work forever.

It's a one-way ticket. Um, and, and this is it for us.

So in that case, deferred revenue goes down, and my equity or retained earnings goes up. And now we've effectively, we're done with that transaction, right? We're done with it. So that was kind of, um, you know, example, uh, one. Now, another example would be the flip side of that, which is when we paid for it first, right? We paid for this first.

So what happens when we paid for it first? Well, if you were the, um, uh, you know, I'm trying to think where, who, who is. This was sort of, uh, the, the wholesaler, uh, and the manufacturer, right? But if you, um, if you paid, if, um, uh, oh, if you, the goods first, but haven't actually paid for it, right? So in that example, I think I said Walmart buys toys from, let's just say Mattel or something, right? Maker of toys. They buy toys from Mattel. So they, they get a big shipment in of the toys Mattel provides, delivers the toys. So from Mattel's perspective, they have a sale, they have revenues. And again, if I drop that revenue into that income statement, untouched by any expense, it comes out all the way at the bottom in net income.

And that immediately trans, uh, translates into retained earnings going up.

Now, did, did Mattel receive any cash? So that's the right hand side of the balance. Did Mattel receive any cash? No, they didn't. If they had received the cash, the cash would be the asset going up. So we'd have asset going up and we'd have equity going up, done.

We didn't receive the cash though, did we? So what Mattel has to recognize here is an account receivable, and that account receivable is then increasing as well, as well.

So my assets have gone up and my liabilities and equity have gone up, right? And we're an imbalance.

And then what happens, of course, when, when, uh, when the bill actually gets paid, well, when the bill actually actually gets paid, um, again, now comes the good part. Um, the account receivable will go down and the cash comes in the door, right? So this is part A, and this is part B. And now, once again, uh, you know, we're kind of back. We're we're, we're back in balance.

So this is effectively, you know, how the income statement works, this concept of revenue recognition and expense recognition.

And, you know, there's a number of different examples of it. We don't have, you know, a ton, ton of time. I'm happy to, you know, clean up, uh, you know, any of this. If we have any time at the end, or, you know, you can message me and I can can do it through the instructor announcements.

But basically what I wanted to establish is that a couple of things.

One is that there are rules to how they do this, right? And they're consistent. Two, the income statement is very much a non-cash document by design. And, you know, you might have heard, um, you know, the expression cash is king on Wall Street and whatnot. And it is, and, you know, we'll talk about why that is, probably when we get more toward valuation and even like private equity, L B O kind of stuff. But, um, we'll start kind of unraveling that expression a little bit at a time.

And what we see here right away is that our income statement in and of itself really has absolutely, or may absolutely have no bearing on cash whatsoever. Now, you may be in a very cash business, and there are plenty of them out there. And believe me, the, the private equity sponsors love them. Um, you know, car washes or cash businesses, laundromats or cash businesses, right? There's not really a lot going on there except kind of the jingling and jingling of coins. Um, but, but in general, I mean, most businesses, and I often use the example of the bakery that my wife had here in Los Angeles, uh, where I am, uh, which, you know, very much was cash based in terms of the way they did business with most of their customers, but also had a very much non-cash component as well, which is, which is how they interacted with some of their bigger, kind of more corporate customers. And so you have to know that, that that inflow and outflow of cash is nowhere to be found on the income statement. So we can show our, our investors an income statement at the end of the year, and it will absolutely have nothing. And they may say, great, um, you know, you made, uh, you know, a a lot of money this year. Congratulations. Uh, look at Amazon, for example. Um, Amazon's do they have, do they have a pro? They have a profit this year, thankfully, uh, this, this quarter, they had a profit. Anyway. Um, if you're an investor, do not think that that's getting mailed out to you in, in, in a check, right? Because it's not, this is not, has no, no, uh, relationship whatsoever to how much cash Amazon made. Um, so hopefully at this point, we've at least established, uh, that, and the last thing that, um, I wanna make clear before I kind of move on is, um, is that the links between the income statement and the balance sheet are therefore many, right? There are many links, uh, these revenues, um, these revenues, for example, um, these revenues, for example, might have accounts receivable related to them. These expenses, right? Might be expenses that, for example, um, if we, uh, if it use my wife's bakery, if they got a huge order in and bought lots of butter, eggs, and flour, um, uh, from their supplier, they might not have paid for that butter, eggs, and flour and sugar before that sale was made.

They may be paying that month or two down the road.

So these expenses are also linked to liabilities. We may owe accounts payable.

So we're starting to see some of these links between the income statement and the balance sheet, which we will continue to explore and unwind.

Don't feel that you have to kind of get all of them, uh, together right now.

Now, I had a, had a, a question come up about, I mentioned this term, you know, private equity sponsors, um, and I know private equities, uh, you know, in, they're, they're on everyone's mind because they're in the news and they're very, you know, very, very, you know, kind of popular these days. But, um, uh, what I mean by private equity sponsors, private equity sponsors are, um, uh, basically funds that are set up by, um, by financial professionals to invest in other companies.

So they buy out companies and take them over and kind of run them, uh, for profit with the hopes of selling them.

That's what a private equity sponsor does. And they, they take money in from, uh, you know, from, from lots of kind of wealthy people and from pension funds and whoever, whoever has a few extra nickels banging around in their pockets and might wanna take a chance on a very risky kind of investment.

So that's what a private equity sponsor does. So, occasionally I mention these things because I know we're all coming from different, different areas and different, you know, different kind of, uh, you know, experiences. But, um, uh, by all means, feel free to, you know, to ask. And then if I, if I think it might be better served for another topic down the road, I might, I might punt a little bit. Um, but, uh, if I say something that you don't understand, please let me know. So, uh, for right now, we will leave kind of that concept of a private equity sponsor.

Just consider them an investor looking to buy businesses. So they, they need to understand these financial statements, right? The same way that you all do. Um, and they're looking at 'em the same way.

So what I'd like to do now is take a, a closer look at the income statement here. And I, what I did was I kind of just copied, copied one from, uh, you know, from, I went over to Felix. I pulled up a company, I just copied the, the, um, the labels in so that we can kind of discuss the layout of the income statement and what this income statement is actually trying to tell us.

So the income statement is divided kind of in a, you know, in a way, um, that's made for us to kind of understand how the business made money and the way the accountants have laid it out.

The segments correspond to sort of different ways.

Businesses are kind of run in a sense.

So I'm gonna focus primarily here on, uh, you know, on, on, um, a manufacturing business.

I think it's easy for us to understand. Um, so the very top of the income statement here, we see this kind of gross profit and this gross profit line here is the first profit line that we come across. And for a manufacturing company, what that gross profit is trying to tell us here is the, um, the direct profit from the product itself.

So the toy manufacturer is effectively what they sell the product for versus what it costs to make the product.

So it's the direct cost of the product itself.

So what does that tell us as an analyst? Well, it tells us, it gives us a sense, a couple of things. I mean, you know, you hear that term all the time.

Is this a high margin business or a low margin business, right? Um, well, you know, I know for example, I, as I mentioned, the, the bakery, the bakery's a very, very low margin business. What do I mean by that? Well, people are only willing to pay so much for, you know, a piece of cake, a donut, a croissant or something. And yet the cost of actually making something, you know, really good is quite high because of the raw, raw ingredients, because of the labor, the, the kind of the specific artisanal labor that goes into making something good. And I'm talking about, you know, a good bakery, like my wife's was, she's out of the business. She reminds me every day, I'm done with that. Um, and, and that, you know, kind of high cost of product, high cost of labor creates what we call a low margin because they just can't mark it up enough to sell it. Now, you know, luxury goods, on the other hand, you think of like a Louis Vuitton bag.

Louis Vuitton bags make nothing cause nothing to make. I mean, there, there couldn't, I mean, I don't, I'm not judging anyone's purchases, uh, but I mean, there, there's not, it's just not a very expensive thing to make.

Um, and there's not even a lot of leather in it in many cases, right? Some of the, the, the baggier ones, right, that have all the logo stuff on there, not even a lot of leather in there, uh, yet, they charge a four hun for it, right? So that's basically a high margin business. What does it cost to make? What does it cost to sell? Now, what Louis Vuitton does incur a lot of is marketing advertising, right? All that kind of stuff.

All the influencers that they have to pay online, the Kardashian bill is quite high, right? So all that stuff is in there.

And so, Uh, sort of expenses here, which is basically all the way down to the operating income.

And these are, uh, direct costs.

So those are what we call the sg and a expenses.

You know, um, I get this message here that my internet connection is stable.

I'm like directly pu plugged in, uh, you know, to, uh, to my connection, I've got a fiber connection, and like the, the, the at and t post is like right outside my window, I feel like saying to Zoom, I think the problem is with Zoom, but, and I got a brand new computer too, but they was like, your internet is stable, so we're just, you know, we're gonna be a little shaky for the next few minutes. I'm like, yeah, right.

Okay, so what does that leave us with? Then that leaves us with what, with what we call the operating income.

And the operating income is therefore effectively The profits from the core business.

So if I opened a bakery, it's the profits from running the bakery, making the donuts, to advertising the donuts, to paying this, paying the mark, the marketing team, and the influence. Everything, everything that goes into running that business is the operating income.

And that's important. It's gonna play a big role for us kind of down the road.

So, um, you know, we'll come back to this concept of operating, you know, income. Uh, again, now, Peter has a question about accruals. I am gonna go back to, uh, accruals in a, in, in a, clear that up for you in one second. Peters, gimme one second. So the, um, the next, um, kind of bit here is what we would kind of look at it. We see interest income, interest expense.

This is clearly now, you know, outside of donuts, right? Outside of croissants, it's really more about financing. Like, how, how did we, how did we, um, finance the business? How do we pay for the business? How do we, how do we pay for the, the capital that's running the business? So these are the financing costs and income, okay? So, um, I, I am gonna go back to Peters, but, um, I've got another question here from Samar, which is a little bit more related to my current point. So, Peter, hang on one second. Didn't forget about you. Samara has asked, what is the difference between operating income and gross profit? So again, the gross profit is just about how do I make a donut? Well, I need, I need sugar, I need flour, I need, you know, whatever I stuff inside it. If it's that kind of donut, I need, you know, person who makes that donut costs this much, I drop it in the grease, the, you know, the oil, the frying, the frying oil comes out, and I charge $4 for it, right? So $4 is the price of that donut, and it costs me $2 and 25 cents to make that donut.

That's the gross profit. Now, my business manager up front is at the same time hiring, uh, you know, a marketing team to market the donut.

I've got influencers all over Instagram, taking, taking pictures of themselves on TikTok and eating a donut and doing crazy things in the middle of the street. So those are, those are now these selling general and administrative expenses here. So by the time I get to operating income, Samara, what I've got here is, is this total representation of the profits that the total bakery business brings in the cost to make the donut and the cost to sell the donut, market the donut, and run the donut business. It's kind of all in there, okay? So that's the difference between gross profit and operating profit.

And if you are, by the way, a service company, if you are a, um, a company that only deals with, with services, like, for example, um, if you're a law firm, you know, or an accounting firm, well, you, you don't have necessarily a gross profit. You may only have an operating profit because you don't make anything, right? All you do is you just kind of talk to people and relate to people and whatnot. So you don't, you don't actually have a product to make.

So again, a gross profit refers to the cost of the product relative to your sales price, operating profit, really, you know, is that next kind of level. So the follow up here is the, the operating income will always be lower than the gross profit, absolutely.

Operating profit has to be, uh, less than the gross profit.

And generally, as we work on an income statement from top to bottom, the sales number's very big, and the net income number is gonna be, relatively speaking, very small. This is kind of a funnel, you know, or maybe better way to look at. It's more of a sieve.

You think about a sieve that kind of, you put a lo a, you know, well, you either have 'em in bakeries too. I don't even think I'm, I'm a one track, uh, teacher here. I can only talk about bakeries, but put, you know, you're, you're a landscaper. You put a bunch of dirt on a sieve and you shake it.

And what, what gets to the bottom holds the rocks up. And what gets to the bottom is just the, the, you know, the fine loom, so to speak, that we're gonna plant in, that's gonna be the net income.

So this is all getting kind of sed out here. So, um, I want to just go back and clear up this, um, this comment for, um, for Peter, um, about, um, accrual.

So this con, this process here, uh, Peter, this process here of, um, not waiting for cash, not caring about when the cash actually comes in, is accrual accounting.

It means that we are adhering to the principles of revenue recognition and matching. So again, if I baked a cake and sold it to, um, you know, if I baked, if I baked, um, if I, if I baked a bunch of cookies and sold them to Starbucks, it's a better example.

If I have not yet paid for the raw materials that go into the cookies, because I just haven't paid those bills, I still have to recognize the expenses that I, I have incurred to make those cookies. The, the, the chocolate, the, the, the, the flour, the sugar, et cetera.

Because those expenses match that sale to Starbucks.

No cash. And Starbucks may not have paid me in cash. So imagine that, Peter, we just did an entire transaction.

Starbucks bought a a thousand cookies from the bakery, didn't pay me cash, and then I did not pay any cash to my food supplier who gave me the raw materials to make the cookies.

So we have a sale, a cost of goods sold, right? A sale, a cost of goods sold.

That's the cost to make the cookies and a gross profit, which is that difference between the two. And in that example, not a dollar of cash changed hands.

Wow. Right? You may say, well, why, why did they set it, set this up that way.

What? Well, it actually makes a lot of sense because it, it really actually keeps everybody kind of using the same, the same rules.

Otherwise, you get a lot of people saying, you know, to their investors, oh, look at our sales. You know, I took a bunch of orders on the phone yesterday. I took, I took millions of orders on the phone yesterday. Look, they're sales. I, I put 'em on the income statement. And someone's like, well, did you really? Right? Did you really take, you know, well, let's, let's actually, you know, let's actually provide the product and then I'm willing to acknowledge that you made a sale, right? So humil, again, GAP is recognition.

Gap, um, is a, is what we call a generally is a is an acronym for generally Accepted Accounting Principle.

And these are, these are the rules that all the accountants have to follow.

So there's Gap, and then there's I F R S, which is the, I don't even, actually, this just came up the other day. I forgot the acronym and I didn't even look it up then too. I was just like, I'll look it up tonight. See what I mean? I told you, you will not remember what we did next week. Just like I didn't remember the, uh, the International Financial Reporting Standards is what I believe it is International. Um, and my colleagues in the UK are just kind of, you know, hanging their heads in shame at me because, uh, financial Edge is actually, um, we're, we're based in the uk even though, uh, I, I, I'm in the LA Outpost here, international Finance Financial Reporting Standards.

So if you're, if you're anywhere else outside the us, um, that's going to be what you, your, the financial statements that you look at. If I go over to Felix and I pull up, if I click on this 10 K link, that's the s e c document.

The SS e c Securities and Exchange Commission requires Amazon to file this document each year, which reports their performance.

This S E C 10 K annual document is reported under, under Gap. And it would actually say that here, financial statements and supplementary data, uh, report of Ernst and Young, let's just see what they have to say. Um, they should see something in here about Gap. It usually does. Uh, they just basically say that we used Gap in compiling this, or the company did, or something like that. They've got another acronym. Acronym in here we don't have to worry about.

But basically that's kind of what's happening here. Uh, notes to consolidated the, this is sort of where all of the accounting policy is reported, so to speak. GAP is a separate, you know, gap, GAP is a separate kind of body that makes independent of the companies I F R S.

Same thing in they, they kind of sit aside and make these rules for all of the, um, companies to follow. So that's kind of how that works.

Okay, so just to go back to, um, so this is, but how can, how can we realize if they report revenues, expenses following recognition versus accrual? Well, um, it's all, it's all done by revenue recognition. Uh, the question is, you know, uh, how do we know if they're reporting revenues, expenses following, you know, a cash basis or accrual? No, it, it, uh, uh, GAP and, and FSB are accrual based.

They are accrual based. We're not doing cash-based accounting in, in, in this, um, to, to report under Gap or under I F R S, which you must, if you are a public company, then you must report accrual-based accounting.

Does that, does that help? There's no, what did they do here? Uh, uncertainty at all. And that's why we, by the way, we will, we will rely very heavily on that third statement here, that cashflow statement, which is gonna help us sort this mess out, so to speak. So let's just, um, let's take a minute here. We're at the, we're at the, um, at the top. Uh, go over to the, um, to that, uh, income statement and an earnings file.

And again, uh, this is just the cover page when you open it up.

If you hit control page down, then effectively what you see here is that you can move up and down these worksheet tabs. Now, um, I have an extra sheet here that I added, 'cause I was just doing some doodling while we were waiting to start up.

But if we go down to, um, uh, uh, to the workout tab, there's some questions here that are gonna kind of help us, um, uh, you know, help us kind of figure this out in a little bit more detail.

Um, the, the first one here, uh, is, is, um, um, this work out one, it says, apply these transactions to the balance sheet formula, ignore the impact of inventory being sold.

So we're just gonna kind of look at these and see if we can understand that accrual, uh, process of recognizing things, you know, that are transactions that did not involve cash.

So super dry sells a t-shirt.

So this can be on their website or, or in their store. Um, how is that going to impact the balance sheet? Well, what's gonna happen here is, um, the asset side is going to go up. That's going to increase. Sorry, this is something is slowing my computer down. Um, the asset is going to, uh, the asset side is going to increase.

Why is it going to increase? Well, because the cash came in. You know, even if we paid with a credit card, by the way, you may say, well, if I pay with a credit card, isn't that we still owe them the money? Well, not really. Credit cards settle like in, in, within a day.

So from super drive's perspective, that's cash. Now, what about on the liability and equity side? Well, once again, if I drop that revenue into my income statement and it comes out the bottom, what does it come out as? It comes out as net income? Net income is therefore going to be a, um, contributed to the equity side of the balance sheet.

'cause that's owned by the shareholders, the shareholders who contributed the capital.

So my liability and equity is going to increase.

I'll just put that here as equity.

And the assumption underlying this is that the cash received by super dry is in excess of the t-shirt's inventory. Yeah, so, exactly.

Now to make it simple here, it says that, that we're ignoring the inventory part of it. So to my, to my question there, um, if we were really, uh, gonna put our accounting hats on and audition for, you know, the Ernst and Young All, all-Star team, then what we would have to do here is say, hold on, let's also adjust the balance sheet for the inventory sold, and let's adjust our profit for the cost of the t-shirt that we sold. And that's exactly what we would do.

And again, if we'd started this, um, you know, we have kind of an intro to financial statements where we kind of talk about that stuff. Uh, which we're, we, we kind of left out of this series. Uh, uh, I'm now thinking, unfortunately, um, we would've seen those kind of transactions happen. But for right now, this is just the sale part of the part of the deal. So, um, now British Airways sells a flight on day one.

The flight takes place in 30 days.

What will be the effect on the balance sheet on day one? Well, um, British Airways, again, similar to that, we kind of went over something like this. The assets increase because of cash, uh, and that's what happened above as well.

And then what happens on the liability side? Well, this is going to be that deferred revenue that's going to increase, that's gonna be that deferred revenue. And if you look on an airline's balance, uh, income statement, they act, or no, sorry, balance sheet, they actually call this sometimes the, um, unearned revenue.

Just another term for things, you know, they like, you know, changing up, uh, sorry, I'm a bad enough typer as it is. I don't need my computer, uh, slowing down on me deferred revenue. So that's a liability, okay? Now what happens is, and again, I kind of went through this, but doesn't hurt to do it again. What happens on day 30? Well, the flight takes place on day 30, and again, I'm gonna assume that we are cashing out of society as we know it, and we're gonna just fly one way to Fiji.

So what's gonna happen here is on the asset side, now nothing actually happens. And, and on the liability side, we're gonna have, um, a, a decrease in the, um, deferred revenue 'cause we no longer owe that we provided the flight.

And then an increase in equity or retained earnings, however you want to think about that from that revenue flowing through the income statement and coming out as profit, right? Obviously no expenses here being considered no taxes, et cetera, et cetera.

Um, and then the next two kind of do more or less the same thing. So I'm gonna, I'm gonna, um, I'm gonna leave that, uh, out of it, um, work out. Uh, number two, um, I'm gonna leave out of this as well. We kind of, kind of talked about some of those, um, topics already. How, how people would recognize, um, how they recognize their revenues. Um, workout three i I would like to do here, um, just because it, it again just helps us firm up these connections between the income statement and the balance sheet. So what we have here, um, is when we look at sales, what are the balance sheet accounts that can be impacted by sales? What are the balance sheet accounts that can be impacted by sales? Well, we just kind of have to look up to our example above, uh, cash, obviously we can sell for cash now. Um, I think it was, uh, was it Samira? I can't re remember Now. They, they clear the, the, the chat, um, asked, you know, uh, how do you know if it's accrual or cash? Um, that doesn't mean that it, that sales can't be for cash.

You can totally still do cash as long as you're still meeting the requirements of what a sale is, right? So there's nothing wrong with making cash sales.

We're not penalizing businesses for making cash sales.

Like it just happened to super dry in the example above. Um, what we're saying is that there are many times when cash doesn't cha trade hands when it still is a sale. So, um, here I've got, uh, sales would be impacted, uh, uh, uh, cash would be, would, could be impacted by a sale. Uh, if I sold, if I sold the goods but didn't collect the cash, Walmart and Mattel example, right? Mattel provided the goods.

That would be an account receivable because we, we are waiting for Walmart to pay us.

And then in the case of the airline industry, if we collected the cash but didn't provide, uh, the sale, that would be deferred. But actually, uh, that wouldn't be a sale. So I'm not even gonna put that down in here. So these are basically the, the main accounts that are impacted by sales, um, uh, cash and accounts receivable. And also, I guess, um, if, if we do record the sale, then we could also, uh, have retained earnings or equity going up as we did above.

Um, now I got a question here again about that inventory being sold.

Uh, question is saying, well, what if we don't, uh, uh, uh, ignore that inventory being sold? Well, you know, that's kind of a, a, a slightly, you know, slightly more, uh, it's just one more level of detail, right? So if I were to kind of draw that out, let's just say, since it's come up twice now, technically not part of our ma you know, material set, but it's come up twice now. So I, I just like to make sure that if I, if a question comes up twice, you know, it means it's time to hit it a little harder, right? So let's say we make a sale, sales are made on account for a thousand, okay? Sales are made on account for a thousand. So not for cash, for account.

And let's just say that the, um, those, those items, um, went into inventory for the cost of 3 25.

So we bought goods. Let's think, say you're a retailer, you bought jeans, your, you know, your true religion. Well, I, I, true religions was on my mind. 'cause I did, I did a bankruptcy case for them. But, uh, um, I think of maybe a, I can't even think like you're Levi's, right? 'cause they're obviously not in bankruptcy. Um, and you make jeans and you sell them to Macy's, right? So Levi's makes a batch of jeans.

Those jeans cost $325 and they sell that batch to Macy's on account for a thousand.

Macy's says I'll pay in 30 days. Levi says, yeah, no problem.

We've been doing business for a hundred years. Pay me in 30 days.

Pay me in 30 days. Okay? So what are the adjust, uh, the um, uh, uh, adjustments here? What are the entries, uh, that we would make well, um, for, uh, the sale. This is again, the, the sale or the retained earnings slash equity is increasing.

So that's the right hand side of the balance sheet by a thousand.

So I'll put that kind of over here to the right.

And then, uh, about left.

So this is liabilities and equity, and this is assets.

And what's my second, uh, transaction here? Well, I'm gonna recognize an account receivable.

An account receivable means I'm owed money by somebody for a thousand, and we're in balance. Fantastic. Now, to your question, how do I recognize the inventory part of it? 'cause that's also going to then establish the gross profit, which was also a question previously as well. Like, you know, what exactly is gross profit? Well, these jeans, the cost of making the jeans, the cotton, the ring spun process that it goes through, the labor to, to do it, the dye, all of that costs 325 bucks.

So now I'm going to recognize a cost of good sold, which means that my retained earnings slash equity is decreasing.

Why? 'cause it's an expense. I'm decreasing it. So I have an expense that's offsetting my revenue, and therefore creating a profit revenue minus expense is a profit. In this case, it's a gross profit.

That gross profit is what would effectively then show up in my equity section. How would it show up? Well, it would show up because that doesn't look like a number because I took in a thousand, but it cost me 3 25 to make that thousand.

So I now have a profit of 6 75.

Now, how do I, how do I go into balance here? Well, I go into balance because I have to decrease as well. My inventory, I'm decreasing my inventory because once I sell something out of inventory, it's gone. It has no future value.

The definition of an asset is that it has future value. Once you sell it, it's gone.

You have to replace it with more value.

You have to make more genes.

So I'm back in balance here because of these two transactions. So that is kind of the, the, the full, you know, full cycle of making a sale. Um, now the last thing I guess that that could happen, uh, for this particular deal is that we could actually receive the cash.

And if we receive the cash, what would happen? Well, if cash would come in, that would be the increase, and that would be the thousand.

And then I write down or eliminate the account receivable because I'm not, I'm no longer expecting to receive from Macy's.

Macy's paid the bill, it's gone. That receivable is over.

So the account receivable decreases.

I We're, we're still essentially back in balance. That's kind of an offsetting deal. Okay? So what I would like to do now is, um, 'cause time certainly flies, um, in these, is I would like to, um, kind of move on to the concept of EBIT and ebitda, because that's a biggie.

And I'm gonna go back to this sort of, uh, get rid of my funnel here.

Go back to, um, my income statement here and start to, um, flesh out this concept of EBIT and ebitda because it's such a big thing in finance, right? Such a big thing. So, um, EBIT and EBITDA is kind of just the, you know, the cousin or, uh, sibling even obviously it's an acronym.

It stands for the earnings before the interest and taxes, right? So that's the EBIT earnings before the interest and the taxes.

Um, and I'll do EBITDA in, in a moment. So, you know, what, what exactly, um, you know, is ebit? Well, if I go back and look at my, my previous sort of drawing here, if I'm looking for earnings or income before interest, which is right here and before taxes, which is right here.

Effectively, what I'm saying here is that my EBIT is more or less my operating income, more or less.

So the first thing we need to understand here is that the reason why EBIT is so important, the reason why EBIT is so important is because it highlights, and this, these are, there's, these terms are now used everywhere, but they really came out of the financial community, EBIT and ebitda, but it highlights for financiers in particular for financial analysts, the earnings that come from the business, from the core business.

So why is that core thing so important? Well, it is because if I'm thinking about, if I'm thinking about buying a business, if I'm thinking about investing in a business, I want to know if what they do well, I wanna know if, if I wanna know what they do well, and I wanna know how much profit they make from it.

So if I look kind of below operating income, what I see here are some things that are related, you know, to the financing. And I see something that's related, obviously to the government.

And then this is the bottom line, right? This is the bottom line, which is obviously impacted by all of that.

So the operating income is not ignoring necessarily the fact that the equity investors are entitled to net net income. It's not ignoring that. But what it's basically saying is, look, you know, interest rates go up and down. Companies have a lot of debt, they have a little debt, taxes go up and down.

I would like to focus my analysis of the business on what this company actually does as its mission.

And that is make jeans, make donuts, make whatever it is, right? So operating income gets us there. Does that make sense? Hopefully it does. Um, operating income therefore gets us. So then, okay, well, if we have operating income, and most companies do report something like that, uh, what do we need EBIT for? Well, EBIT kind of goes a step further.

Sorry, I'm lost here. EBIT goes a step further.

It highlights the earnings that come from the core business.

We'll call that the operating income.

And then it actually normalizes, it normalizes those earnings. So what do I mean by normalizes? It, it's the adjusts for any non-recurring, non-continuing expenses or income.

So as companies get more complicated and get bigger and more complicated, they tend to have a lot of these things sort of come up, you know, in, in a year. They have, um, things that just kind of happen, you know, things that you didn't expect to happen that happen.

And those can oftentimes result in a particular period a year or a quarter in losses or, or expenses, potentially found income, right? There may be a lawsuit that you won or lost. Uh, there may have been a plant closing, a store closing.

Macy's closes a store. A lot of expenses associated with that.

Severance pay fees to the, to the property owner that, that, to close out the lease. These are, these are kind of, you know, what we call one off items.

And these are the kinds of things that we need to adjust for with ebit. Now, everything that I say about EBIT applies to ebitda.

EBITDA just has one more layer of complication to it, which is the da, right? And I'll get to that.

So anything that is a one-off item that hits the income statement above the operating income line, we're gonna wanna adjust for, and that's gonna give us a normalized or adjusted EBIT number.

So let's take a look very quickly at, again, these, these problems, and let's see if we can, um, you know, if we can just sort of highlight, you know, a couple actually. And before we do that, let me, well, uh, yeah, let's take a look at these problems. Let's take a look at the problems first, and then we will, um, so in workout six, we're being asked to calculate ebit.

So what we get here is kind of a nice, neat income statement, very similar to what, you know, if we pulled one up online, what we would get and what we see here is these are almost line for line, the items that I showed you on, um, you know, on my income statement in the PowerPoint, almost line for line, they're not showing gross profit here, but you could slide that in right here and show a gross profit.

They are showing operating profit, right? Uh, and this is also kind of part of the complexity of it, is that not every company reports the same exact accounts.

You do not have to show a gross profit number, break the news to you, but you actually don't have to show an operating profit number either.

That doesn't mean that you don't have to show all of these accounts, but it's up to the company to decide how they wanna break down their income statement.

And that's what makes our job sometimes as analysts a little bit more complicated. So if you're just beginning your journey on this, you know, don't worry about that. If, if you've been doing some research, you know, some, uh, you know, some analytical work, then you might, you know, know this. Or if you come from an accounting background, you know, you might know this, right? So, um, so in this case, we don't have a gross profit. We do have an operating profit. So immediately, you know, the bell should be going off that this is going to be kind of where I hone in on for my EBIT calculation. So, you know, is, is that all there is, right? As, as the song says is, is that all there is to this? Well, no, because, you know, it would not be, uh, a difficult, that difficult a job if all we had to do was kind of take the company's, you know, word for it. The reality is, is that there's a lot going on behind these numbers.

And if we were to actually go into this, um, this is the filing document for Amazon, right? This is hundreds of pages.

If you were to actually, uh, you know, uh, you know, the expression Netflix and chill.

If you were to kind of 10 K and chill for the night, meaning curl up on the sofa with a 10 K and just read it for a couple of hours, you would find out a lot of interesting stuff about Amazon. And what you might find is that regardless of, um, let's see if I go to their financial statements, regardless of what they're showing you here, um, on this, uh, income statement, which again, looks a little bit like what we've got here. We've got sales, cost of sales, a bunch of expenses, and then operating income.

Again, that 22 8 9 9 seems like it's the EBIT number.

But if we had spent a couple of hours reading through this report, we might actually find that there's some stuff buried in the notes that we need to actually consider as being non-recurring, non-continuing one-off kinds of items.

And in this problem here, they're telling us, Hey, we found a bunch of stuff in the notes.

What do you think about these? Well, depreciation and amortization, these belong to ebitda.

So we're not gonna consider these. Meaning that th this, all of this stuff in these four lines is included in this nine 80. So we're okay with this.

That's fine.

Rent and energy bills are also included in this. Now, does that sound like a non-recurring, non-continuing one-off item to you? I'm gonna say that I hear from you. No, it does not sound that way, so that's fine. We're okay with that. And what about office staff salaries? Okay, we're fine with that as well. I mean, those have to get paid.

And what about advertising expense? Those are good too.

So after all that buildup and all that kind of explaining, what it turns out is that after our two hours of 10 K in chill with Amazon, we've got the understanding that all of their expenses that they reported and that we dug up actually are recurring, are continuing, are not one-off. So our operating profit, therefore, is equal to our ebit.

Any, uh, any questions on that? Okay, so that being the case, before you spend another two hours with a 10 K on the sofa, what are the kinds of expenses that we have to look for? Well, you're gonna see a lot of things come up in an annual report in a 10 K or Q that we have to decide, does this expense contribute to a regular or recurring expense, or should we be adjusting EBIT for it? So I'm gonna take a look, uh, at this list very quickly, kind of go through it and if you have any questions about it, feel free to ask me, but I think it's a good kind of good, you know, way to sort of spend time. So I'm, I'm gonna do that and we'll still have time to kind of rock and roll through ebitda. Um, restructuring expenses are always non-recurring. Um, litigation losses always non-recurring.

No business should incur enough litigation that they should be normalized, right? Logistics, the process of delivering goods, that's fine.

That's recurring gain on selling a business. Well, that doesn't come up very often. We don't, we're not, we should not be in the business every day of, of, you know, selling our assets.

So that would be a non-recurring business too.

So that what this is implying here is that our income is inflated, our operating income is inflated by this gain.

And that means, of course, that, you know, we would have to adjust for that and we'll do a problem with some of these below, uh, impairment of a subsidiary. We, we realize that our subsidiary has to, we have to close down a bunch of, bunch of buildings and factories. It's not what we thought it was that same thing, non-recurring, uh, insurance expense, run of the mill warehouse, security run of the mill, um, loss on disposal of fixed assets. So if we get rid of some, some of our goods and we incur a loss on them, that should also be, uh, a, a, um, non-recurring. This is not selling inventory.

This means to say, Hey, you know, um, we've got some, um, some, some trucks we wanna sell, we don't need 'em anymore.

We're gonna outsource our logistics. Um, we paid this much for the trucks, but we're selling them at a loss, so I have to take a loss on the, the trucks. That's a non-recurring loss.

Now, we have a question here. If a company is undergoing a restructuring and is undertaking a reduction in force, but this is, um, taking, uh, projected to take place over multiple years, will we consider this to be one-off in nature? Yeah, absolutely.

Many of these great question.

Many of these kinds of expenses actually do occur in multiple years. So what's important, however, is that we only actually write off what's being closed or sold or written down in that year. So in other words, if I'm the c e o of a company and I just say, look, we've got about, you know, we've got about 500 million of assets we have to write down, let's do a do a three year plan. We'll do the Illinois plant tomorrow, the Illinois plant's closing, that's 200 million. Next we'll do the Ohio plant. That's a hundred million in year two.

So we would not expect to see that 100 for the Ohio plant closing in year two. And then in year three, uh, the California plant, I wanna hit the Midwest too hard with this, uh, closure.

So I'll hit my home state. Uh, so, you know, two, one and two, and that's how it would happen. So you'd have three years. Now, a follow-up question to that might be, well, if it's happening in three years, is it still non-recurring? And the answer is 99% of the time, yes, it is, because this is still, you know, not part of the everyday business of this company.

Shutting down businesses, closing assets down, selling assets, even if it happens in, in a couple years, three years, four years straight. Um, you know, we have to still kind of give the benefit of the doubt here that this is a non-recurring item. So, plant shut down, non-recurring audit fee. I, I, I'm kind of on the fence about this and I'm gonna call it, you know, to me, if you get audited, that's kind of a once in a while, thing, I'm gonna call it non-recurring. That should be a pretty small amount, right? Um, we should not, you know, lose sleep and stay up all night over insignificant, immaterial amounts. So hopefully an audit fee's gotta be pretty massive, you know, for it to really stand out in the, you know, in the analysis.

Severance costs, absolutely non-recurring, um, lease breaking penalty.

So Macy's closes a store and has to pay, uh, Westfield or Brookfield or Simon properties is a massive payout that's definitely not par for the course, even in retail where they're going outta business left and right.

We still consider store closing costs to be rare, uh, gain from a lawsuit, non-recurring, uh, cost of providing warranties that's recurring. Write down, uh, recurring, uh, non-recurring, um, salaries of the front office staff. That's recurring.

Uh, office rental expense, uh, that's recurring. Obviously, integration expenses due to acquisition that's non-recurring.

I'm gonna give you some hints here. 'cause you know, you could go on forever with this stuff. Um, a any, I'll do it on the notes here, anytime you see, uh, m and a related expense, merger, acquisition slash integration, anytime you see the word restructuring, write down impairment.

Anytime you see gains or losses within the this context, I will bet you, and no pun intended, a dollar to a donut, that these are non-recurring items, gains losses, uh, re restriction, writedown impairment.

I think those are the big ones. So let's just do, uh, one more of these as ebit, and then I'm gonna shift over to EBITDA. And, uh, if I can get through ebitda, I'll feel really, um, I'll feel like we accomplished something, something meaningful.

So, um, these can kind of keep going and going and going, but I, I'll, I'm gonna post the solution to this as as well.

But you can start to see a trend here. Impairment, right? M and a, right, uh, cost due to natural disaster. Somebody, you just start to see a trend here, you can kind of figure these out, right? So, um, what I wanna do here is let's do workout eight, but first let's calculate ebit, and then I will use this problem to shift over into EBITDA and cover this concept of EBITDA and kind of get us up to the hour.

So remember I said if you can do ebit, you can do ebitda, and there's no daylight in ebit, the EBIT of EBITDA and ebit, there's no daylight here.

You should not have an EBIT calc that's different than the EBIT base of ebitda. They're always the same. We just add the d n A at the end. Okay? So here, once again, we have an income statement, rather straightforward, just like above. And then once again, we spend a night on the sofa with the 10 K at our, at our manager's request, and we find some stuff in the notes that we want to bring up. Well, the first thing we find is that they had some research and development expenses, research and development. What do we think about that? Well, research development probably for most companies is par for the course.

Any company that needs r and d is spending r and d that's gonna be par for the course. So unless you see, and this is very common, something called acquired r and d, which once again, we hit that m and a, right? Merger and acquisition topic acquired r and d, that's gonna be one-off, but regular r and d run of the mill.

Okay? Next thing we found is a legal claim provision for product recall.

So we have to recall some products.

So we're taking that hit on our income statement right away, and that's included. That's, that is a 10, I'm just gonna say million dollar expense that is included in our SSG. And a, so what is happening here, if I start, let me do EBIT first here.

What is happening here with ebit? Well, what I'm saying is I go, I start with my profit before interest in tax.

So that's going to be the, what, what this company calls operating profit profit before interest in tax, right? So again, you're gonna see these different names come up.

Profit before interest in tax is 10 93 0.9.

So I'm gonna go ahead and I'm gonna link to that 10 93 0.9. Now, what's happening here is that the selling general and administrative expense is overstated by this 10 million because of this, right? This, um, recall. So if we're thinking about normalizing this company's earnings, so we can understand on a, on a recurring basis, right? What's, what can we count on from this company? If my expenses are overstated, it means that my earnings or earnings were understated by this 10.

So I want to go in here and add this 10 back to my profit before interest in tax to get that, to get that to an adjusted level.

Okay? Any questions on, on that? Any questions on that concept of, um, of, of what I did there? So, great follow up question is why would a company want to understate their profits from the core, the core business? So, um, grav, what's happening here is that it's not whether they want to, the accountants are telling them they have to, the accountants are telling them that they must take this right down, they must take this hit 'cause it's a genuine business expense, and it's happening in this period.

So according to Gap and according to I F R S, they have to do this.

Now, we are not saying as financiers, as as investment banking analysts or, or analysts of equity research, we're not saying that, that we disagree with the accountants. We're, what we're trying to do is we have a different look, a different point of view, and we wanna get a sense of what this company, you know, kind of regularly generates.

So we're just trying to normalize it so that we can then compare it to another business and then determine, you know, should we buy business A or business B? I can't do that.

If business A in 2023 is having a really, really tough year of these one, if items write downs, expenses, severances. So their income is understated, right? Their expenses are overstated, their income is understated.

And I'm comparing it to company B. Company B is having a great 2023, they had a bad 2022. So you can see I'm, I'm in the apples and oranges dilemma.

I can't compare their earnings because they've got these weird things that are hitting their books each year. They're, they're, they're totally acceptable from, you know, if we're just looking at, you know, understanding the business, they're acceptable, but we can't get a handle on the true profitability if we're considering them.

'cause we don't expect them to come up every year so that that's why they're in there and that's why we're taking them out. So, Ika, why did we exclude r and d? Is it, isn't it one-off, no.

Research and development should not be one-off.

Research and development should be ongoing because if you are in, if you're a tech company, if you're a healthcare company, if you're a software company, you should absolutely be incurring research and development.

It should be part and parcel of the business.

So we should not wanna adjust for r d every now and then a company will acquire some r and d from another company because they, a company might have a, a business idea and spend some money developing it and they don't want to. And then a company says, Hey, we want that idea. We're gonna buy that from you.

And you say, great, we, you know, we're done with it. You can have it. So you'll sell the r and d to, you know, to the new, to the other company.

In that case, that would be a rare example of a, uh, you know, of excluding a company's r and d expense. But normally we would not.

Okay? So what I'm gonna do now is I'm gonna shift, um, into the concept of ebitda, which is again, sort of the, you know, the cousin to ebit and you know, what EBITDA is going to do is, is gonna take ebit, everything we just talked about and it's gonna add back depreciation and amortization to it. So I'll write that out. 'cause we may have, some people here are new to all of this stuff to depreciation and amortization.

So first thing we have to understand is what is depreciation and amortization? Well, de depreciation and amortization is another accounting accrual kind of, I'll call it a gimmick. I don't really mean to sound so harsh.

It's another, it's another, um, uh, you know, another principle of accrual accounting and what that says.

Basically the is that, you know, a company buys an asset, buys a, uh, large asset.

Let's say, let's say they buy, you know, um, you know, a new, they build a new headquarters or they buy, um, a new fleet of trucks or a new, a new set of, um, you know, computers for their entire staff.

So they buy a large asset.

And let's think about this from our discussion of the income statement that asset has, is expected to be used over several years, right? They're long, they're long-term assets, right? So what the accountants say is, hang on, wait a minute.

You cannot run that expense through the income statement because matching principle is in place.

The matching principle says that you, if you bought your staff new computers, let's just say, you know, for, um, let's say you, you're a call center, right? You provide, you provide, um, support, tech support.

Well, those computers don't just support the revenues from year one.

Those computers support revenues over the next five years until you buy new computers. Those computers get old and you buy new ones.

So what the accountants say is you can only expense in year one, one fifth of that expense of that asset expenditure. So the expenditure or expensing of the asset must match the revenue cannot expense the entire asset purchase.

So if I buy, you know, a thousand dollars of equipment in year one or at the beginning of year one, and I decide that they have a five year useful life, I can only expense 200 in year one, 200 in year two, 200 in year three, et cetera, et cetera, et cetera.

So the reality is, is that the cash was spent at the beginning of this five-year time period.

But these 200 of expenses are what actually gets recorded on the income statement.

This is called depreciation. We are depreciating the value of the asset by 200 each year to show that we are using the asset up. We're using it up.

The reality though is that this 200 is not an actual cash flow at that point. 'cause the cash is spent here, the cash is spent here.

This represents accrual.