Analyzing financial statements often involves the application of several financial and economic concepts.  This page reviews a few of these concepts:  accounting profit, depreciation, opportunity cost, return on assets (ROA) and return on equity (ROE).

Accounting Profit or Net Income

By preparing an income statement, an accountant calculates the profit earned by the business for the period covered by the income statement.  However after the income statement is prepared, it is the responsibility of the manager to assess the information.  For example, the manager would want to determine whether the profit was adequate to justify continuing to operate the business.

• Likewise after the cash flow statement is completed or the balance sheet is prepared, the manager needs to decide whether there was adequate net cash flow or whether the change in equity was acceptable.

• Similarly if a projected cash flow statement is prepared, the manager needs to decide whether the projected cash flow is adequate to proceed with the planned effort.

The accountant can prepare the financial statements, such as the income statement, but it is the manager who must decide whether the financial progress, as reported by these financial statements, is adequate.

In making that assessment, the manager will want to consider several concepts, such as depreciation and opportunity cost.

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Accounting profit is the amount that remains after subtracting costs from the revenue generated during the accounting period.

The accounting period is determined by the business manager; it could be a year, 6 months, 3 months, monthly, or whatever time period the manager wants to analyze.

Revenue is the value of production or output produced during the accounting period, whether or not the production was sold.

Costs are the value of inputs used to produce the output during the production period.

A component of calculating revenue and cost is to track the number of units or quantity of input used and the quantity produced.  Often in the past, accountants would have a beginning inventory of inputs and output, record the quantity of output sold and the quantity of input purchased, and then have a closing inventory.  For these data, the accountant would calculate the quantity used or the quantity produced.

Quantity sold during the production period + ending inventory - beginning inventory = quantity produced during the production period.

Quantity of input in inventory at start of production period + quantity of input purchased - ending inventory = quantity of input used during the production period.

With today's information technology, these quantities should be directly observed rather than calculated.  How many bushels of grain were harvested from each field?  How many pounds of feed were fed to each pen of livestock each feeding time?  What items and what quantity of each item were sold through the retail store today?  This past hour?

Managers may still want to make some of these calculations but it is better (I would suggest) for managers to directly track inputs used and output produced.

Accounting profit for the accounting period is calculated as revenue for the accounting period minus costs for the accounting period.

Costs can be considered as "paying someone else for the use of their resources in your business".

Accounting profit is the "return the business owner receives for using their own resources in their own business".

• Review 1) the six types of economic resources (land, labor capital, information, business reputation and assumption of risk) and 2) the idea that a) these resources can be acquired from someone else to use in your business or b) these resources can be owned and provided by the business owner.

The manager then needs to decide whether the accounting profit provided an adequate return to the business owner for the resources the business owner owns and used in the business; that is, "did I receive an adequate return for my resources that I used in my business or should I discontinue using my own resources in my business?"

• Recall that opportunity cost is the economic concept which underpins a resource owner's assessment of whether the current use is the best use for those owned resources.

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Calculating Profit

Revenue - Cost = Accounting profit

Is the accounting profit an adequate return for the business owner's use of the business owner's economic resources?

Accounting profit - Opportunity cost for the business owner's resources used in the business = Economic profit

If economic profit is zero or greater, the business generated an adequate return for the business owner's economic resources.

Alternative Thought Process

Impose an opportunity cost for some of the business owner's economic resources and then ask whether the economic profit is providing an adequate return for the business owner's remaining economic resources.

Example:  Accounting profit - opportunity cost for the business owner's land and capital = return earned by the business owner for the use of the business owner's labor, information and assumption of risk

Is this return to labor, information and assumption of risk adequate to justify the business owner's continued use of labor, information and assumption of risk in this business?

• The assumption in such a calculation is is that the opportunity cost imposed for land and capital is adequate to justify the continued use of the land and capital in the business operation.

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Summary of Key Points

Accounting profit is the return a business owner receives for the use of the business owner's economic resources in the business. The business owner must decide whether whether the accounting profit provides an adequate return to justify continuing to use the business owner's economic resources in the the business owner's business.