Finance explained to my mother-in-law. Chapter VII – Income Statement

Reclassifications in management accounting are generally quite free and adaptable to the company structure without imposing rigid schemes such as the chart of accounts and the accounting principles of general accounting.

While this allows some flexibility in detail (which costs to consider variables, for example, and which costs to consider fixed), the general layout, which is recognised and adapted worldwide, makes it possible to compare comparable things quickly and smoothly.

The general scheme foresees:

  • Sales
  • Variable costs (sales and production) – COGS (Cost Of Goods Sold)
  • Contribution Margin
  • Fixed production costs – Manufacturing Costs
  • Gross Margin
  • Other fixed costs – Selling and General Administrative expenses (SG&A)
  • Operating profit (EBIT)
  • Financial result
  • Earnings Before Taxes (EBT)
  • Income Taxes
  • Net result

And then the world-famous indicators:

EBITDA – Earnings Before Interests, Taxes, Depreciation and Amortization
EBIT – Earnings Before Interests, Taxes
EBT – Earnings Before Taxes
ROS – Return on Sales

We talked about Turnover and Fixed and Variable Costs in the previous chapters, one more word deserves now the Cost of Goods Sold (COGS).

For the relation Costs – Revenues, only the costs functional to the “generation” of Turnover should be included in the Income Statement.

As far as purchases of Raw Materials are concerned, therefore, not all of them will end up in the Income Statement.
The portion not used for production/sales during the year will remain in the Financial Statements as “Inventory Value”.

Knowing that: Initial Inventories + Purchases – Consumption = Final Inventories

For Raw Materials the Consumption of the year (Cost of Goods Sold – COGS) will be calculated accordingly as :

  • Initial Inventory + Purchases – Final Inventory
    which is equivalent to
  • Purchases – Inventory variation

For the Finished Products unsold during the year, not only the Raw Materials will end up in the Inventory value but also the share of the costs (salaries, depreciation, energy, etc.) used to produce them.

Once correctly valued, the Variation of Finished Products Inventory allows to calculate the Consumption (Cost of Goods Sold – COGS).

As far as the result indicators are concerned:

  • the EBIT corresponds to the Operating Result, therefore:
    Turnover – Variable Costs – Fixed Production Costs – Other Fixed Costs (SG&A)
  • Included in Fixed Costs are Depreciation and Amortization and Provisions which are not Monetary Costs but “accounting entries” which allow to maintain the relationship Costs – Revenues for the year. Excluding these costs from EBIT, we obtain EBITDA which corresponds to the “cash flow” generated by the Income Statement.
  • EBT corresponds to the Pre-tax result.
  • By dividing each indicator by Turnover, you get percentages according to the Sales much used to compare different companies: “My Ebitda is 20%, yours only 6%” and so on.
  • The most famous indicator in percentage is the ROS – Return On Sales which corresponds most of the times to the Net Result or EBIT divided by Sales.