Statement of Retained Earnings 343
depreciationis an annual charge against income that reflects the estimated dollar cost
of the capital equipment used up in the production process. Depreciation applies to
tangible assets,such as plant and equipment, whereas amortizationapplies to in-
tangible assetssuch as patents, copyrights, trademarks, and goodwill. Some compa-
nies use amortization to write off research and development costs, or the accounting
goodwill that is recorded when one firm purchases another for more than its book
value. Because they are similar, depreciation and amortization are often lumped to-
gether on the income statement.
Managers, security analysts, and bank loan officers often calculate EBITDA,
which is defined as earnings before interest, taxes, depreciation, and amortization.
MicroDrive currently has no amortization charges, so the depreciation and amortiza-
tion on its income statement comes solely from depreciation. In 2002, MicroDrive’s
EBITDA was $383.8 million. Subtracting the $100 million of depreciation expense
from its EBITDA leaves the company with $283.8 million in operating income
(EBIT). After subtracting $88 million in interest expense and $78.3 million in taxes,
we obtain net income before preferred dividends of $117.5 million. Finally, we sub-
tract $4 million of preferred dividends, which leaves MicroDrive with $113.5 million
of net income available to common stockholders. When analysts refer to a company’s
net income, they generally mean net income available to common shareholders. Like-
wise, throughout this book unless otherwise indicated, net income means net income
available to common stockholders.
While the balance sheet can be thought of as a snapshot in time, the income state-
ment reports on operations over a period of time,for example, during the calendar year
- During 2002 MicroDrive had sales of $3 billion, and its net income available to
common stockholders was $113.5 million. Income statements can cover any period of
time, but they are usually prepared monthly, quarterly, or annually. Of course, sales,
costs, and profits will be larger the longer the reporting period, and the sum of the last
12 monthly (or four quarterly) income statements should equal the values shown on
the annual income statement.
For planning and control purposes, management generally forecasts monthly
(or perhaps quarterly) income statements, and it then compares actual results to
the budgeted statements. If revenues are below and costs above the forecasted
levels, then management should take corrective steps before the problem becomes
too serious.
What is an income statement, and what information does it provide?
Why is earnings per share called “the bottom line”?
Differentiate between amortization and depreciation.
What is EBITDA?
Regarding the time period reported, how does the income statement differ from
the balance sheet?
Statement of Retained Earnings
Changes in retained earnings between balance sheet dates are reported in the state-
ment of retained earnings.Table 9-3 shows that MicroDrive began the year with
$710 million of retained earnings, earned $113.5 million during 2002, paid out $57.5
million in common dividends, and plowed $56 million back into the business. Thus,
the balance sheet item “Retained earnings” increased from $710 million at the end of
2001 to $766 million at the end of 2002.
Financial Statements, Cash Flow, and Taxes 339
