1. Earnings and the operating cycle

The operating cycle forms the basis of the company’s wealth. It consists of both:

• additions to wealth (products and services sold, i.e. products and services whose worth is recognised in the market); and
• deductions from wealth (consumption of raw materials or goods for resale, use of labour, use of external services such as transportation, taxes and other duties).

The very essence of a business is to increase wealth by means of its operating cycle.

It may be described as gross insofar as it covers just the operating cycle and is calculated before non-cash expenses such as depreciation and amortisation, and before interest and taxes.

2. Earnings and the investing cycle

3. The distinction between operating costs and fixed assets

Although we are easily able to define investment from a cash flow perspective, we recognise that our approach goes against the grain of the traditional presentation of these matters, especially as far as those familiar with accounting are concerned:

• Whatever is consumed as part of the operating cycle to create something new belongs to the operating cycle. Without wishing to philosophise, we note that the act of creation always entails some form of destruction.
• Whatever is used without being destroyed directly, thus retaining its value, belongs to the investment cycle. This represents an immutable asset or, in accounting terms, a fixed asset (a “non-current asset” in IFRS terminology).

For instance, to make bread, a baker uses flour, salt and water, all of which form part of the end product. The process also entails labour, which has a value only insofar as it transforms the raw material into the end product. At the same time, the baker also needs a bread oven, which is absolutely essential for the production process, but is not destroyed by it. Though this oven may experience wear and tear, it will be used many times over.

This is the major distinction that can be drawn between operating costs and fixed assets. It may look deceptively straightforward, but in practice is no clearer than the distinction between investment and operating outlays. For instance, does an advertising campaign represent a charge linked solely to one period with no impact on any other? Or does it represent the creation of an asset (e.g. a brand)?

4. The company’s operating profit

From EBITDA, which is linked to the operating cycle, we deduct non-cash costs, which comprise depreciation and amortisation and impairment losses or write-downs on fixed assets.

This gives us operating income or operating profit or EBIT (earnings before interest and taxes), which reflects the increase in wealth generated by the company’s industrial and commercial activities.

The term “operating” contrasts with the term “financial”, reflecting the distinction between the real world and the realms of finance. Indeed, operating income is the product of the company’s industrial and commercial activities before its financing operations are taken into account. Operating profit or EBIT may also be called operating income, trading profit or operating result.

5. Earnings and the financing cycle

6. Recurrent and non-recurrent items: extraordinary and exceptional items, discontinued operations

We have now considered all the operations of a business that may be allocated to the operating, investing and financing cycles of a company. That said, it is not hard to imagine the difficulties involved in classifying the financial consequences of certain extraordinary events, such as losses incurred as a result of earthquakes, other natural disasters or the expropriation of assets by a government.

They are not expected to occur frequently or regularly and are beyond the control of a company’s management – hence, the idea of creating a separate catch-all category for precisely such extraordinary items.

We will see in Chapter 9 that the distinction between non-recurring and recurring items is not an easy one, all the more so as accounting regulatory bodies do little to help us.

Among the many different types of exceptional events, we will briefly focus on asset disposals. Investing forms an integral part of the industrial and commercial activities of businesses. But it would be foolhardy to believe that investment is a one-way process. The best-laid plans may fail, while others may lead down a strategic impasse.

Put another way, disinvesting is also a key part of an entrepreneur’s activities. It generates exceptional “asset disposal” inflows on the cash flow statement and capital gains and losses on the income statement, which may appear under exceptional items or not. It is for the analyst to decide whether these gains and losses are recurring, and thus part of the operations; or not, and then constitute non-recurring items. More generally, some non-recurring items have a cash impact, some have none (goodwill depreciation, for example).

By definition, it is easier to analyse and forecast profit before tax and non-recurrent items than net income or net profit, which is calculated after the impact of non-recurrent items and tax.

7. Net income

Net income measures the creation or destruction of wealth during the fiscal year. Net income is a wealth indicator, not a cash indicator. It incorporates wealth-destructive items like depreciation, which are non-cash items, and most of the time it does not show increases in value, which are only recorded when they are realised through asset sales.

1. The by-function income statement format

This presentation is based on a management accounting approach, in which costs are allocated to the main corporate functions:

As a result, personnel expense is allocated to each of these four categories (or three where selling, general and administrative costs are pooled into a single category), depending on whether an individual employee works in production, sales, research or administration. Likewise, depreciation expense for a tangible fixed asset is allocated to production if it relates to production machinery, to selling and marketing costs if it concerns a car used by the sales team, to research and development costs if it relates to laboratory equipment, or to general and administrative costs in the case of the accounting department’s computers, for example.

The underlying principle is very simple indeed. This format clearly shows that operating profit is the difference between sales and the cost of sales irrespective of their nature (i.e. production, sales, research and development, administration).

On the other hand, it does not differentiate between the operating and investment processes, since depreciation and amortisation is not shown directly on the income statement (it is split up between the four main corporate functions), obliging analysts to track down the information in the cash flow statement or in the notes to the accounts.

2. The by-nature income statement format

The by-nature format is simple to apply, even for small companies, because no allocation of expenses is required. It offers a more detailed breakdown of costs.

Naturally, as in the previous approach, operating profit is still the difference between sales and the cost of sales.

In this format, costs are recognised as they are incurred rather than when the corresponding items are used. Showing on the income statement all purchases made and all invoices sent to customers during the same period would not be comparing like with like.

A business may transfer to inventory some of the purchases made during a given year. The transfer of these purchases to inventory does not destroy any wealth. Instead, it represents the formation of an asset, albeit probably a temporary one, but one that has real value at a given point in time. Secondly, some of the end products produced by the company may not be sold during the year and yet the corresponding costs appear on the income statement.

To compare like with like, it is necessary to:

• eliminate changes in inventories of raw materials and goods for resale from purchases to get raw materials and goods for resale that were used rather than simply purchased;
• add changes in the inventory of finished products and work in progress back to sales. As a result, the income statement shows production rather than just sales.

The by-nature format shows the amount spent on production for the period and not 
the total expenses under the accruals convention. It has the logical disadvantage that it seems to imply that changes in inventory are a revenue or an expense in their own right, which they are not. They are only an adjustment to purchases to obtain relevant costs.

Exercise 1 will help readers get to grips with the concept of changes in inventories of finished goods and work in progress.

To sum up, there are two different income statement formats:

• the by-nature format, which is focused on production in which all the costs incurred during a given period are recorded. This amount then needs to be adjusted (for changes in inventories) so that it may be compared with products sold during the period;
• the by-function format, which is built directly in terms of the cost price of goods or services sold.

Either way, it is worth noting that EBITDA depends heavily on the inventory valuation methods used by the business. This emphasises the appeal of the by-nature format, which shows inventory changes on a separate line of the income statement and thus clearly indicates their order of magnitude.

Like operating cash flow, EBITDA is not influenced by the valuation methods applied to tangible and intangible fixed assets or the taxation system.

Summary

Exercises

Answers

Bibliography