OTHER ARTICLES IN THIS SERIES

Two weeks ago, I started a new series called " Learnin's From My MBA." The series is meant to take business concepts I've learned in my MBA program and present them to you, an audience of scientists with no business background.

The first part of that series, entitled "The Annual Report," gave a brief summary of the different sections of an annual report and what they can tell you about a company. Last week, in the second part of the series, I looked at the qualitative part of an annual report, the president's message. Together, we examined what that section is supposed to contain and how to read between the lines to locate the company's strategic issues and agendas.

This week is the third part of the annual report series. It's the first time we'll discuss the actual quantitative financial figures found in the report. This is meant as an introduction to basic financial reporting.

There are three big financial statements in an annual report: the statement of cash flow, the balance sheet, and the income statement. Each statement tells us a little bit about the company but is pretty useless without the other two. However, because this is an introduction, we've got to start with one of the statements. Today we're going to dissect the income statement. Similar to studying physiology, there are a lot of things we're going to do today that won't make any sense until you learn about the other financial statements (or systems) that interact with the income statement. (The other two won't be covered until next week.)

Again, we'll be using a real annual report (PDF format) from a real company called Alta Genetics Inc.

The Income Statement

The first thing you should notice about Alta Genetics's report is that you won't be able to find an income statement. Instead, you'll notice something called a "consolidated statement of loss." It's the same thing. Like many other fledgling biotech companies, Alta Genetics isn't making money yet: They're losing money, as expected for the first couple of years of a biotech start-up. Remember, you've got to buy equipment, perform research, and develop a product before you can start making money. So instead of calling it an income statement, they call it a statement of loss.

The next thing you should notice is that the income statement is labeled "Years Ended December 31." The income statement is not a snapshot of where the company is right now but a history of what they did all year. While the other two financial statements we'll be discussing later are snapshots of where the company is on 31 December of any given year, the income statement provides you a yearly activity summary. This is a very important difference which will become clearer as we go through the statements.

OK, so we've gotten through the first two lines. What next? First, at the top, we see a ($000's). That means that all of the numbers on the rest of the page are in thousands of dollars, so a 12 on the income statement is really $12,000. It's important to keep that in mind. Then, you see a description of the item on the left side of the page and two columns of figures on the right. The columns on the right are labeled 1997 and 1996, and they mean what you might think they mean: The first column's figures are the figures for the year ended 31 December 1997, and the second column's figures are the figures for the year ended 31 December 1996. Nice and simple so far.

Next we've got a bunch of descriptions of what the numbers stand for. They won't change much from one income statement to the next, except that they might break down the categories a little bit more than they do in this statement. But that's OK--I picked this statement because it's got all of the basics without any really complicated stuff. We'll be going through the statement, line by line, to understand what it really means.

Revenue

The revenue line indicates the amount of money that was paid (or promised to be paid) for stuff that you sold. Basically, if you did a series of minipreps for someone and charged them $50, that would be $50 worth of revenue. It doesn't really matter whether they paid you, as long as they were going to pay you at some point soon.

We can see that Alta Genetics has sold $50 million worth, about 10% more than they sold in 1996 ($45 million).

Cost of Sales

The cost of sales line indicates the cost of making what you sold in the revenue line. So for the same miniprep analogy used in the revenue line, the cost of doing the miniprep might include the cost of a technician's time and the cost of reagents and equipment. Many companies separate these costs, giving you a better description of the different types of costs, but our company has consolidated all of their costs of goods sold in one line.

We can see here that although Alta sold more in 1997 than they did in 1996, it cost them less to make their stuff. This is unusual--normally the more you sell, the more you've got to make, and the more it costs you to make that stuff. But who knows? Maybe they're more efficient now or they're selling their stuff for more money (increasing their margins). We don't really know how this is happening, but we know that it's good. If you can sell more stuff, and it costs you less to make it, you're winning both ways!

Gross Margin

The gross margin is simply the revenue minus the cost of sales. It's what you've actually made for the year, not counting your fixed costs (costs not directly related to the cost of sales), interest costs, taxes, management costs, and advertising costs. Back to the miniprep example: Say it costs you $3 for tubes and reagents to do a miniprep. It takes your technician an hour at $10 an hour, so your total cost of sales is $13. Your gross margin would therefore be $37 ($50 in revenue less the $13 it cost you to make the stuff). The gross margin is what you can put in your pocket at the end of the day. But wait! You (as the manager of Minipreps Inc.) haven't been paid yet, because your costs weren't directly related to the cost of sales! That ad you put in Science to advertise your miniprep company hasn't been paid for yet either! And don't forget the taxman! That's why this is only the third line of the income statement--the rest of the page will discuss those expenses. Gross margin is your margin on goods sold, before your fixed costs.

Expenses

This section discusses your fixed costs.

Selling and Administration

The selling and administration expense is the cost of marketing, management salaries, maintaining sales force, and the like. A lot of companies separate this into "Administration" and "Sales and Marketing," but it's the same. It shows the costs of all the paychecks, the ads to make your business known, and the office you've got to rent in order for the big manager-types to do all that work.

Your miniprep business would add up these costs and represent them here. It would include the costs of your time (as a manager of the business), the ads you ran in Science, the three salespeople you hired, and, of course, that big leather chair you bought yourself "so you could think."

Research Expenses

This is exactly what you'd think: It's the cost of doing research not directly related to a sale. In your miniprep business, if your technician spent an hour a day trying to figure out a new, more efficient way of doing minipreps, the cost of that person's time and materials would appear in this category. Usually, a biotech business will have a huge research expense recorded simply because they're trying to find the cure for some disease they haven't developed a product for yet. Because the cost of that research can't be directly attributable to a contract (a big pharma didn't give you tons of cash to answer a question for them), you have to expense those research costs instead of putting them in your cost of sales line.

Amortization

Amortization is very similar to depreciation, if you've heard that term. Basically, if a centrifuge can run 5000 times, and you've run it 50 times for the minipreps you did this year, you've got to expense 50/5000 of the cost of that machine. For depreciation, you use years instead of times used, so if the average life of a centrifuge is 10 years, you would depreciate its cost over that time span and expense 1/10 of the cost of the machine every year.

There are all sorts of ways accountants calculate depreciation and amortization. None of them are really all that important here. Just remember two things: First, it's supposed to be a way of reflecting the 'using up' of plants and equipment over time, or over the use of the item. Second, because there are about a million ways of calculating depreciation, you shouldn't base a lot on this number. Depreciation can be quite different from company to company without really meaning that one company used up more stuff than another.

Some big picture estimates can be made, though. If a company has less capital expenditures (something we'll look at in our cash flow statement next week which means "new plant and equipment stuff bought") than they're depreciating or amortizing, it means that the company is using up more than they're replacing. This means they're kind of reducing their asset base or not really maintaining their stuff. Also, if they're spending more than they're depreciating, it usually means they're growing, or at least their physical presence (the stuff they have in their factories) is growing.

Earnings (Loss) Before Interest and Income Taxes

This number is simply the gross margin, less the expenses. It's a reflection of what you've really made this year, without counting for expenses, and the cost of the money you borrowed. Here, Alta Genetics seems to be doing quite well. They made over $2.7 million this year, where last year they had lost over $1.5 million. The term "Earnings (Loss)" simply means that if there are brackets around the number, it's a loss (or a negative number), and if there aren't, it's earnings, or a profit.

Interest on Short-Term Debt

This is the amount of interest the company had to pay on their short-term debt through the year. It includes any company credit cards or rotating lines of credit. Short-term debt might also include interest paid on phone bills and equipment you bought but didn't pay for till after the due date. This line item represents how much interest the company paid on these things. It comes right out of their revenues because it must be paid to the bank or other debtor on top of the usual cost of the item purchased.

Interest on Long-Term Debt

Long-term debt is debt that doesn't have to be paid off this year. This interest expense might include interest paid on a mortgage, a long-term bank loan, or some other debt.

Dividends on Preferred Shares

Dividends are amounts of money paid out to shareholders. Preferred shares are a certain class of shares where people get a fixed rate of interest back on the money they invested in the company. So this line shows that there are many people that bought preferred shares and were paid interest in the form of a dividend on the money they invested in Alta Genetics.

Write-Down of Capital Assets

This line item is what's called an extraordinary item. It's not something you'd find in a standard income statement, but it happens every now and then. Usually, as is the case here, there's a little asterisk next to the description, referring to a note at the end of the annual report. This note explains exactly what happened and why.

The write-down of a capital asset is exactly that--it's a downward adjustment of the value of something the company owns. This downward adjustment has to be expensed. For example, a piece of equipment that was supposed to last 20 years only lasted three, or a piece of equipment was suddenly rendered obsolete. Or in the case of Alta Genetics, the company sold land that had a higher value on their books than the actual sale price. Basically, they sold something that their books indicated was worth $863,000 for $443,000, requiring a write-down of $420,000 on their books. (These things happen).

Earnings (Loss) Before Income Taxes

This is the earnings (loss) before interest and income taxes, less all the interest and write-down expenses. It's how much money the company made this year and how much they're taxed on.

Income Taxes--Current and Deferred

This is what the company owes in income taxes, based on the money they made this year. The Current line indicates the amount they've paid the tax collector; the Deferred line indicates the amount they owe and will pay in the next year.

Loss Before Non-Controlling Interest

This is the net income or loss of the company, after all the taxes have been paid. If the company was actually making money, the line would be called "profit before non-controlling interest."

Non-Controlling Interest

This is basically the amount of money made through an interest in another company. Basically, if Alta Genetics owned shares in some other company (but not a controlling interest where they controlled that company), they would have to declare any amount they made from their ownership in that company here. It would be transferred over from the second company's books to the books of Alta Genetics. In any case, we don't have any here. Most companies don't have large non-controlling interests in other companies, so this line item isn't used much and isn't important for the purposes of this discussion.

Net Loss

This is the amount of money the company made in 1997 after all expenses, taxes, and the like have been paid. This line would be called Net Profit if Alta Genetics had made any money in 1997.

Loss Per Share

This is a helpful reminder to the shareholders. It indicates the net loss divided by the amount of shares outstanding in the company. It allows shareholders to figure out what the net loss was per share. It doesn't mean that the money will be taken or given to the shareholders. Also, the share price is only partially determined by the net profit or loss of a company, but this number serves as an indicator that we'll use when we're doing basic financial analysis later on.

So there you have it. In the next couple of weeks, we'll be tackling the balance sheet and cash flow statement. Once you've got the terminology down, that's when the real fun begins--we'll be taking these numbers and manipulating them to try to figure out what they really mean.

Next: Finance 1, The Balance Sheet in the Annual ReportPart IV of "Learnin's From My MBA" Series