Understanding The Numbers
The three pieces which help you put the puzzle together are the Balance Sheet, Income Statement(Profit & Loss) and Cash Flow (+ the footnotes.) These are the key financial statements which together help you fully appreciate a company's current health. In isolation they provide you insight which could be misleading. All three of these statements are related and you need to understand them with respect to the other.
(If this is your first time, reading these statements, this takes a while initially, and this article is certainly longish, however, my aim is to give you enough in one shot.)
(For US listed companies there are two other statements, the 10Q(quarterly) & 10K(annual) they are a comprehensive report of a company's performance that must be submitted quarterly by all public companies to the Securities and Exchange Commission, the Indian counterpart is SEBI(Securities and Exchange Board of INDIA.).
The balance sheet helps to answer certain key questions,
# How much money has been invested in this company?
# What kind of assets does the company have?
# How much debt does the company have?
# Can the company meet it's financial obligations?
The balance sheet represents a record of a company's assets, liabilities and equity (Net worth) at a particular point in time. In order to acquire assets, a firm must pay for them with either debt (liabilities) or with the owners' capital (shareholders' equity). Therefore, the following equation must hold true:
|Assets = Liabilities + Shareholders' equity|
or Shareholders Equity = Assets - Liabilities
(If Assets or Liabilities are wrongly represented, Shareholder's Equity or Net worth can disappear pretty quick...)
Assets are of two types: Current Assets & Non-Current Assets.
A) Current assets - which are likely to be used up or converted into cash in a short period, typically 12 months, or one business cycle
B) Non-Current Assets - Anything not classified as a current asset, e.g. Property, Plant and Equipment (PP&E).
Current Assets are of 4 kinds:
- Cash Equivalents (These are generally highly liquid, short-term investments such as government securities and money market funds which can be quickly converted to cash.)
- Inventory (Finished products, that haven't been sold)
- Receivables (Outstanding payments which are yet to be received)
These 4 kinds of assets provide good clues to how well the company is managed.
Cash heavy or low?
People always like to see a company with a good level of cash, a growing cash pile is indicative of a strong business, however if it's lying around for too much time, it might mean the company doesn't know what to do with it, at times companies return in the form of dividends, excess cash generated from the business, which they might not be able to allocate more profitably. On the other hand dwindling cash reserves might indicate the company is chewing more than it can, or it might also mean that the company is putting the money to good use, e.g. a company is opening up more stores to generate even more income. I'll come back to cash again when we examine the Cash Flow statement.
Non-Current Assets or Long Term Assets
- Fixed assets such as Property, Plant & Equipment(PPE)
- Intangible assets are non-physical assets such as copyrights, franchises, patents and goodwill. To estimate their value is very difficult because they are intangible. Often there is no ready market for them.
- Depreciation is the gradual loss in value of equipment and other tangible assets over the course of its useful life. Accountants use depreciation to allocate the initial purchase price of a long-term asset to all of the periods for which the asset will be used.
Analyzing the Balance Sheet
The long term assets on a Balance sheet are things to watch out for. When both market and book value are available for an asset, accounting rules often require that you use the lesser of the two numbers. This often hides the true value of an asset which has appreciated, e.g. land held by the company. Another thing to watch out is Accounts Receivable, absent a decisive declaration of a bad debt, firms may continue to show as accounts receivable amounts that they know are unlikely to be ever collected, giving a distorted picture of the income.
The Profit & Loss or Income Statement, is your guide to how the company is making money (it's sources of revenue) and how it's spending it. It's expenses in manufacturing the goods(COGS-Cost of goods sold) and expenses in operating the business(SGA - Selling, General and Administrative Costs). The income statement is used to determine, the companies profitability. (Note: PROFIT DOESN'T MEAN CASH IN THE BANK. That seems strange doesn't it. Well I'll explain more when I get to the CashFlow statement.)
Simply put profit = revenues - expenses.
Ok that's simple, however, as they say the devil is in the details.
To understand profitability better, it makes sense to understand it at multiple levels.
"Gross profit" on Sale, is calculated as revenue(total or net sales) minus cost of sale. For e.g. if a company buys or manufactures goods at 10 bucks and sells it for 12 bucks, it's gross profit is 2 bucks.
Gross Profit = Net Sales - Cost of Goods Sold
Cost of goods sold is what the company spent to make the things it sold. Cost of goods sold includes the money the company spent to buy the raw materials needed to produce its products, the money it spent on manufacturing its products and labor costs. (Note: It doesn't include sales or marketing expenses, salaries, rent, and R&D costs.)
Gross Margin is the resulting percentage when Gross Profit is divided by Net Sales. Therefore, Gross Margin represents the percentage of revenue remaining after Cost of Goods Sold is deducted.
Companies with high gross margins typically have a lot of money left, to spend on other business operations, such as R&D or marketing. A downward trend in the gross margin rate over time could signify future problems facing the profitability or bottom line. When cost of goods sold rises rapidly, they are likely to lower gross profit margins, unless, the company can pass these costs onto customers in the form of higher prices. If a company is able to maintain a high Gross Margin, it's often indicative of a strong business.
As Warren Buffet once said "You can measure a business over time by the agony they go through in raising prices. You're not in a great business if you have to have intense management debates and a prayer session before you raise prices." (Source: http://deepwealth.blogspot.com/2005/07/master-classes-buffett-munger.html)
Profitability on another level can be expressed as Operating income, also referred to as Operating Profit. It is a company's earnings from its core operations, after deduction of cost of goods sold and its general operating expenses(Operating Expenses = Expenses incurred in the day-to-day operation of running a business such as sales or marketing expenses, salaries, rent, and R&D costs.).
Operating income does not include interest expenses or other financing costs. Nor does it include income generated outside the normal activities of the company, such as income on investments or foreign currency gains, or sale of a land bank etc.
Operating income is particularly important because it is a measure of profitability based on a company's operations. In other words, it assesses whether or not the foundation of a company is profitable. It ignores income or losses outside of a company's normal domain.
An easy way to calculate operating income is as follows:
Operating Income = Gross profit - General Operating Expenses - Depreciation Expense
General operating expenses are normal expenses incurred in the day-to-day operation of running a business. Typical items in this category include sales or marketing expenses, salaries, rent, and research and development costs.
Depreciation is the gradual loss in value of equipment and other tangible assets over the course of its useful life. Accountants use depreciation to allocate the initial purchase price of a long-term asset to all of the periods for which the asset will be used.
Operating Income is a more reliable measure of profitability since it is harder to manipulate with accounting tricks than net earnings or Net Income.
Operating Margin. Operating margin is the resulting ratio when Operating Income is divided by Net Sales.
|Operating Margin =||--------------------------|
A company with a high operating margin in relation to it's industry peers has operations that are more efficient. Typically, to achieve this result, the company must have lower fixed costs, a better gross margin, or a combination of the two. Companies that are more efficient than their competitors in their core operations have a distinct advantage.
Net income generally represents the company's profit after all expenses, including financial expenses, have been paid. This number is often called the "bottom line" and is generally the figure people refer to when they use the word "profit" or "earnings". Net income is the sum of operating and non-operating income. Non-operating income is typically referred to as "other income" and "extraordinary income" (or loss). During bad years companies may boost their Net Income, by selling of land or other assets, thereby, showing a higher Net Income. Unfortunately the media always touts this Net Income or Bottomline, watch out, as it can be misleading.
A company with a high profit margin, usually means that it also has one or more advantages over its competition. Companies with high net profit margins have a bigger cushion to protect themselves during the hard times. Companies with low profit margins can get wiped out in a downturn. And companies with profit margins reflecting a competitive advantage are able to improve their market share during the hard times - leaving them even better positioned when things improve again.
Income Statement Analysis
By analyzing an income statement properly, you can begin to evaluate, the effectiveness, of the management of operations in a company. It helps identify good investment opportunities and also reduce the risk involved with choosing a poor investment choice.
CASH FLOW STATEMENT
The Cash Flow statement specifies the sources and uses of cash of the firm from operating, investing and financing activities, during a period(Quarterly/Annually). It sounds very much like the Income statement however the two differ. The income statement records revenues and expenses using Accrual Accounting, and also includes non cash revenues or expenses. For e.g. A company may show net income of $100 however this doesn't mean that they actually increased their bank balance by $100. They might receive that money post the current financial year. Whereas if the bottom of the Cash Flow statement shows a $100 net cash inflow it means they have received the money. Sometimes companies juggle around the Income statement to show a profit on the income statement. A close examination of the cash flow statement can give investors a better sense of how the company will fare.
A company can produce and consume cash in different ways, for instance, cash can come from products it sells, investments the company makes, debts it takes or by selling stock and bonds. Due to this the cash flow statement is divided into three sections: cash flows from operations, financing and investing. The statement of cash flows can be viewed as an attempt to explain how much the cash flows during a period were, and why the cash balance changed during the period.
Cash Flows from Operations(CFO)
This section shows how much cash comes from sales of the company's products/goods and services, less the amount of cash needed to make and sell those goods and services. Changes in CFO typically offer a preview of changes in net future income. Normally it's a good sign when it goes up. A gap between a company's reported earnings and its cash flow from operating activities could be a sign of trouble. If net income is much higher than cash flow, the company may be speeding or slowing its booking of income or costs.
Cash Flows from Investing (CFI)
This section shows how much cash a company is spending in capital expenditures, such as new equipment or anything else that needed to keep the business going. It also includes acquisitions of other businesses and investments such as money market funds.
Cash Flows from Financing (CFF)
This is where the company reports the money that it took in and paid out in order to finance its activities. This section describes typical sources of cash inflow by selling stock and bonds or by bank borrowings(debt). Similarly, paying back a loan would show up as a use of cash flow, also, dividend payments and common stock repurchases would show up here.
Analyzing the Cash Flow Statement
You want to see a company re-invest capital in its business by at least the rate of depreciation expenses each year. If it doesn't re-invest, it might show artificially high cash inflows in the current year which may not be sustainable. Another variable which is carefully watched is the amount of Free Cash Flow(FCF) that a company generates. Free cash flow is defined as follows:
FCF = Net Income + Depreciation / Amortization -Changes in Working Capital - Capital Expenditures
Free cash flow signals a company's ability to pay debt, pay dividends, buy back stock and facilitate the growth of business. Free cash flow, which is essentially the excess cash produced by the company, can be returned to shareholders or invested in new growth opportunities without hurting the existing operations.
How much cash return a company is generating, is a good measure of well the company is performing. CROIC or the Cash Return on Invested Capital is a good indicator of the same.
Free Cash Flow
Equity + Total Liabilities - Current Liabilities
Typically look for companies with a high CROIC >= 15%
Lastly I'd like to leave you with the following:
100, 120, 189, 200, 225, 240, 280, 300, 325, 340
Suppose, the above numbers were the 10 year revenue numbers for X company. The first impression would make it seem that the company is a consistently growing company. However this is the wrong way at looking at numbers. It helps to examine the Growth Rate or Rate of growth of the numbers to get a true picture of the company.
On calculating the growth rates, here is what you would see:
What you see is a company whose revenue growth is slowing down over a period of time.This presents a completely different picture of how the company is doing. Over a nine year period it's growth was 15% however over time it's current growth rate has slowed down to 5%. Definitely not a company you would want to be invested in. Always see numbers as Growth rates to get a better picture.