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20 Financial Statement Analysis

inception of the company. From the owners’, or shareholders’, point of view, equity rep-
resents their claim on company assets. A slightly different way to describe the accounting
equation is in terms of sources and uses of funds. That is, the right-hand side represents
sources of funds (either from creditors or shareholders, or internally generated) and the
left-hand side represents uses of funds.
Assets and liabilities are separated into current and noncurrent amounts. Current
assets are expected to be converted to cash or used in operations within one year or the
operating cycle, whichever is longer. Current liabilities are obligations the company
is expected to settle within one year or the operating cycle, whichever is longer. The
difference between current assets and current liabilities is called working capital.
It is revealing to rewrite the accounting equation in terms of business activities—
namely, investing and financing activities: Total investing Total financing; or alterna-
tively: Total investing Creditor financing Owner financing.
Remember the accounting equation is a balance sheet identity reflecting a point in
time. Operating activities arise over a period of time and are not reflected in this
identity. However, operating activities can affect both sides of this equation. That is, if
a company is profitable, both investing (assets) and financing (equity) levels increase.
Similarly, when a company is unprofitable, both investing and financing decline.
The balance sheet of Colgate is reproduced in Exhibit 1.5. Colgate’s total invest-
ments (assets) on December 31, 2006, are $9.14 billion. Of this amount, creditor
financing totals $7.73 billion, while the remaining $1.41 billion represents claims of
shareholders.

Income Statement
An income statement measures a company’s financial performance between balance
sheet dates. It is a representation of the operating activities of a company. The income
statement provides details of revenues, expenses, gains, and losses of a company for a
time period. The bottom line, earnings (also called net income), indicates the profitabil-
ity of the company. Earnings reflects the return to equity holders for the period under
consideration, while the line items of the statement detail how earnings are determined.
Earnings approximate the increase (or decrease) in equity before considering distribu-
tions to and contributions from equity holders. For income to exactly measure change
PRO FORMA MESS
Some companies have in equity, we need a slightly different definition of income, called comprehensive in-
convinced investors that come, which we discuss in the section on links between financial statements later in this
they should measure chapter.
performance not by earnings The income statement includes several other indicators of profitability. Gross
but by pro forma earnings. profit (also called gross margin) is the difference between sales and cost of sales (also
Pro forma earnings adjust
GAAP income by adding called cost of goods sold). It indicates the extent to which a company is able to cover
back certain expense items. costs of its products. This indicator is not especially relevant for service and technol-
One example is the popular ogy companies where production costs are a small part of total costs. Earnings from
EBITDA, which adds operations refers to the difference between sales and all operating costs and expenses.
back depreciation and It usually excludes financing costs (interest) and taxes. Earnings before taxes, as the
amortization expense. Pro
forma earnings shelter name implies, represents earnings from continuing operations before the provision for
companies from the harsh income tax. Earnings from continuing operations is the income from a company’s
judgment of a net income continuing business after interest and taxes. It is also called earnings before extraordinary
calculation. For example, items and discontinued operations. We discuss these alternative earnings definitions in
the S&P 500’s pro forma Chapter 6.
earnings were 77% higher
than GAAP net income for a Earnings are determined using the accrual basis of accounting. Under accrual
recent year. accounting, revenues are recognized when a company sells goods or renders services,