Chapter 3
FINANCIAL ANALYSIS : Earnings

A distinction needs to be made between cash and wealth. Spending money does not neces- sarily make you poorer and neither does receiving money necessarily make you any richer. Additions to wealth or deductions from wealth by a company are measured on the income statement. They are the difference between revenues and costs that increase a company’s net worth during a given period.

From an accounting standpoint, operating costs reflect what is used up immediately in the operating cycle and somehow forms part of the end product. On the contrary, fixed assets are not destroyed directly during the production process and retain some of their value.

EBITDA (earnings before interest, taxes, depreciation and amortisation) shows the profit k generated by the operating cycle (operating revenues − operating costs).

As part of the operating cycle, a business naturally builds up inventories, which are assets. These represent costs, the impact of which needs to be eliminated in the calculation of EBITDA. In the by-nature format, this adjustment is made to operating revenues (by adding back changes in finished goods inventories) and to operating costs (by subtracting changes in inventories of raw materials and goods for resale from purchases). The by-function income statement shows merely sales and the cost of goods sold requiring no adjustment.

Capital expenditures never appear directly on the income statement, but they lead to an increase in the amount of fixed assets held. That said, an accounting assessment of impair- ment in the value of these investments over time leads to non-cash expenses, which are shown on the income statement (depreciation, amortisation and impairment losses on fixed assets).

EBIT (earnings before interest and taxes) shows the profit generated by the operating and investment cycles. In concrete terms, it represents the profit generated by the industrial and commercial activities of a business. It is allocated to:

• financial expense: only costs related to borrowings appear on the income statement, since capital repayments do not represent a destruction of wealth;

• corporate income tax;

• net income that is distributed to shareholders as dividends and/or transferred to thereserves (as retained earnings).

  Transactions that do not fit into the other categories are included under non-recurring income.