Chapter 3 Financial Statements, Cash Flow, and Taxes 63that depreciation is an annual charge against income that re" ects the estimated
dollar cost of the capital equipment and other tangible assets that were used up in
the production process. Amortization amounts to the same thing except that it
represents the decline in value of intangible assets such as patents, copyrights,
trademarks, and goodwill. Because depreciation and amortization are so similar,
they are generally lumped together for purposes of! nancial analysis on the in-
come statement and for other purposes. They both write off, or allocate, the costs
of assets over their useful lives.
Even though depreciation and amortization are reported as costs on the income
statements, they are not cash expenses—cash was spent in the past, when the as-
sets being written off were acquired, but no cash is paid out to cover depreciation.
Therefore, managers, security analysts, and bank loan of! cers who are concerned
with the amount of cash a company is generating often calculate EBITDA, an ac-
ronym for earnings before interest, taxes, depreciation, and amortization. Allied
has no amortization charges, so Allied’s depreciation and amortization consist en-
tirely of depreciation. In 2008, Allied’s EBITDA was $383.8 million.
While the balance sheet represents a snapshot in time, the income statement
reports on operations over a period of time. For example, during 2008, Allied had
sales of $3 billion and its net income was $117.5 million. Income statements are
prepared monthly, quarterly, and annually. The quarterly and annual statements
are reported to investors, while the monthly statements are used internally for
planning and control purposes.
Finally, note that the income statement is tied to the balance sheet through the
retained earnings account on the balance sheet. Net income as reported on the
income statement, less dividends paid, is the retained earnings for the year (e.g.,
2008). Those retained earnings are added to the cumulative retained earnings from
prior years to obtain the year-end 2008 balance for retained earnings. The retained
earnings for the year are also reported in the statement of stockholders’ equity. All
four of the statements provided in the annual report are tied together.
Depreciation
The charge to reflect the
cost of assets used up in
the production process.
Depreciation is not a cash
outlay.Depreciation
The charge to reflect the
cost of assets used up in
the production process.
Depreciation is not a cash
outlay.
Amortization
A noncash charge similar
to depreciation except
that it is used to write off
the costs of intangible
assets.Amortization
A noncash charge similar
to depreciation except
that it is used to write off
the costs of intangible
assets.
EBITDA
Earnings before interest,
taxes, depreciation, and
amortization.EBITDA
Earnings before interest,
taxes, depreciation, and
amortization.Why is earnings per share called “the bottom line”?
What is EBIT, or operating income?
What is EBITDA?
Which is more like a snapshot of the! rm’s operations—the balance sheet or
the income statement? Explain your answer.SELF^ TEST (^)
3-4 STATEMENT OF CASH FLOWS
Net income as reported on the income statement is not cash; and in! nance, “cash
is king.” Management’s goal is to maximize the price of the! rm’s stock; and the
value of any asset, including a share of stock, is based on the cash " ows the asset
is expected to produce. Therefore, managers strive to maximize the cash " ows
available to investors. The statement of cash! ows as shown in Table 3-3 is the
accounting report that shows how much cash the! rm is generating. The statement
is divided into four sections, and we explain it on a line-by-line basis.^8
Statement of Cash
Flows
A report that shows how
things that affect the
balance sheet and income
statement affect the firm’s
cash flows.
Statement of Cash
Flows
A report that shows how
things that affect the
balance sheet and income
statement affect the firm’s
cash flows.
(^8) Our statement of cash " ows is relatively simple because Allied is a relatively uncomplicated company. Many
cash " ow statements are more complicated; but if you understand Table 3-3, you should be able to follow more
complicated statements.