Monday, August 06, 2007

Research Series Part 5 – The Income Statement

For Part 5 of the research series, I will focus on the Income Statement which is also called the Profit and Loss Statement. The aim is to highlight key areas for investors to review so that one may get a feel of how the company is doing and whether things look good for it in future. This is the (usually) first financial document most investors (and punters even) look at, as it tells immediately if the company is doing better or worse than the previous year. Remember though, that the Income Statement itself is a good reflection of the company’s business, and by going through the details one can readily pick up many signals about how the company is performing, and what its future will be like.

Below are listed several aspects of the Income Statement which are worth noting, please note that this list is far from exhaustive and that every company has its own unique items within the Income Statement; but this is meant to serve as a guide for most businesses:-

1) Revenue Growth – This is measured as the revenue increase in a given period versus the revenue from the previous period, as a %. Generally, a company should exhibit revenue growth, otherwise it’s obvious the company’s products and services are not selling well ! Another reason for revenue growth could also be increased prices of products for sale, when a company which is a franchise has pricing power to raise prices without affecting demand (e.g. SMRT and SBS Transit). Demand has to be relatively inelastic in order to price increases to justify revenue growth. In most cases, companies grow sales by selling more products or increasing their product lines.

2) Cost of Goods Sold – The relationship between revenue growth and COGS growth is very interesting. Most companies would report an increase in revenue (otherwise, why be in business right ?); but not many can report a correspondingly high or higher increase in gross margin. Why is this so ? Because cost of goods increases to eat up margins, such that even though revenues may grow, costs grow even more (see “Gross Profit” section below).

3) Gross Profit and Gross Margin – Gross profit is simply sales minus cost of goods sold; but this relationship is very important as it represents each additional dollar of earnings from one dollar of product cost. After all, the main aim of a business is to buy something cheaper in order to sell it more expensively (thus the term profit). Gross margin is defined as gross profit divided by revenue. In some cases, margins can get squeezed. A simple example to illustrate the gross profit cum margins scenario: assume revenues are $10K and costs of goods sold $5K in the FY 2006 for company X (thus yielding a gross profit of $5K or a gross margin of 50%). For FY 2007, revenues are up 100% to $20K, while costs are only up 80% to $9K. This yields a gross profit of $11K (a 120% increase) which is a margin of 55% (improvement of 5 percentage points for gross margin).

Notice how the gross profit improvement exceeds both the increases in revenues and COGS ? This is the power of reducing costs while keeping revenue growth steady. A lower than proportionate increase in COGS will ensure a higher gross profit increase and a higher gross profit margin.

Usually, companies which see their GP margin decrease are facing some sort of price pressure, or stiff competition. Industries which are becoming commoditized will face declining margins even as sales volume and value increases, to the detriment of shareholders. If a company is in a franchise position and is able to increase prices without suffering a corresponding increase in COGS, then it is able to improve margins in the long run. There are also companies which cut costs rigorously by employing economies of scale or better techniques and processes; all of which are a result of internal restructuring. Remember that cost cutting usually affects only the net margin (to be elaborated on) line and that gross margin will represent the fundamental nature of the business. If gross margins fall, this is a clear danger signal which should be investigated without hesitation.

4) Selling and Marketing Expenses – This expense tends to remain relatively constant in proportion to sales. Instances which could jack up this item disproportionately will include intensive promotions or advertising to increase sales, more roadshows and higher expenses incurred to close sales or to provide services. If a company has to spend additional marketing dollars just to generate an equivalent level of sales, then there must be something seriously wrong with its current product or service offering. It is best that the company re-examine their strategy in order to ensure no marketing dollars are wasted in a bid to maximize sales.

5) General and Administrative Expenses – The two main “large” items within this category usually relate to rental costs (for office and/or warehouse and factory) as well as staff costs. Rental cost will only get higher with the current property boom with rentals in office areas going as high as S$10 per square foot. Note that rental expenses are not applicable if a company has purchased the land and building in which it is operating on (in this case, refer to depreciation expense which should be a constant year-on-year). Staff costs are also set to rise due to higher salaries being demanded in the market as well as the restoration of the 1.5% to employer’s CPF. Even staff costs in China companies may escalate as the economy is booming and growth is projected to exceed 10%. This would imply that the cost of living will eventually get higher and companies will have to pay correspondingly higher wages to maintain the same staff pool.

6) Finance Costs – Trust me, this item can be a killer expense if it gets out of control. Finance costs would include costs of borrowings which literally means interest expenses on loans and convertible bonds. If a company is highly geared (i.e. high debt/equity ratio), then expect interest costs to be relatively high with respect to earnings. In a rising interest rate environment, this can be the nail in the coffin as interest expenses keep ramping up and eating into cash. Thus, always be wary of high gearing companies. As PAH is highly geared currently (117%), I am also keeping a watchful eye on their Cash Flow Statement to see if they are able to generate sufficient cash to cover their finance costs.

7) Exceptional Items – Exceptional items usually consist of one-time non-recurring charges or credits to the Income Statement. Some examples are write-down of inventory, writing off of bad debts, impairment losses from an investment (e.g. DBS has to write-down as impairment losses part of their stake in a Thai bank) or gain from sale-and-leaseback transactions. These must be taken out of net profits and adjusted before earnings per share calculations, as they will distort the picture for the investor. Only CORE earnings from operating activities should be used to compute EPS, as this represents the earnings from the business which can be reinvested back into the business to grow it. Some charges (e.g. impairment losses) can also be written back, and it is up to the individual investor to educate himself on the accounting aspects of such items.

8) Net profit and NP margin – Net profit increases usually indicate that Management has been effective in keeping costs to an acceptable level while growing the business. The net profit margin (adjusted for exceptional items) is a good indication of whether the selling and admin expenses of the company are growing faster than revenues. The two margins (i.e. gross and net) must be read in tandem and compared against previous quarters and/or years in order to ascertain if the business is improving or deteriorating.

This brief write-up should act as a useful summary for those who wish to begin analyzing the Income Statement. Remember to be on the lookout for the above items and practice looking at many companies’ statements in order to get a feel of things. I myself try to download 80-90% of all listed companies’ Income Statements just to practice my analysis skills. Usually, there will be a disconnect between the press release (which tends to promote the good stuff and gloss over the bad) and the actual financials. Try to go through it on your own with a fine-tooth comb and you’ll be surprised what you can find !

The next part of the research series shall focus on the Balance Sheet and show readers the important aspects to look out for in this often-neglected financial document.


Ivan said...

Hi there

Just visited your blog.

Contains a wealth of infomation!

Will definitely support your ads and put a link to your blog on mine. We can complement each other!

I am still on a steep learning curve for share investment...

I look out for:

- P/E ratio
- Debt to Equity ratio
- Debt to Assets ratio
- Debt to liquidity ratio
- future expansion plans
- barriers to entry
- pending patents and regulatory approval

... cHeeRs

musicwhiz said...

Hi Ivan,

Thanks for dropping by. Hope my blog can help to share more knowledge and information and together, we can invest with a better understanding and clearer mind.

Those points you look out for are also on my radar, but in varying degrees. If you follow my research series (it's part 5 now), you will see how I screen companies but so far I haven't had the time to do much research.

Glad to know you are also learning about share investment. I think trading these days is all the rage but is causing many people to lose tons of hard-earned savings. Investing, on the other hand, helps to build your nest egg slowly.

Will visit your blog now and then as well to comment. Cheers...:)

Anonymous said...

Hello MW,

Profit for the year is normally splited into attributable to 1). Equity holders of the Company and 2). Minority interests, and hence a company net profit is much lower distorting the picture.

With PAH increasing its stake in CFG, this still accounted as Minority interests? Is this the same as having more than 30% and hence a Majority holder rule? If indeed so, than PAH FY08 net will be extremely rosy, looking at FY07 figures.

Next, is PAH way of accounting for Net Profit for Equity holders a common practice? For an investor looking out for dividends and a much lower net, he will get short change? Your thoughts please.

musicwhiz said...

Hi Anonymous,

Yes, profit is split according to the proportion held by equity-holders (you and me) as well as minority interests (MI). When we say MI, we have to see how many of their subsidiaries are wholly-owned (i.e. 100%). Those which are not fully-owned will have to transfer part of their profits to MI under proportionate consolidation method of accounting. This is the adding up of line by line in the Profit and Loss for all subsidiaries and then deducting the MI portion of the profits. A corresponding credit can be seen in the Balance Sheet for MI.

With PAH increasing its stake in CFG to 63.9%, the MI portion will now be 36.1%, meaning that 36.1% of CFG's profits still accrue to MI. Note that anything above 50% control qualifies as a subsidiary and undergoes proportionate consolidation. For 20% to 49%, it is accounted for as an associated company and you can see the line "share of profits of associated company" in the Income Statement. There is no MI for associated companies as it is equity accounted for. For holdings of 20% of less, it is accounted for as an investment in the books which is subject to impairment tests on a yearly basis.

Yes, PAH's "way" is actually according to accounting standards (i.e. FRS) so there is nothing wrong with that. PAH are simply trying to crystallize more value from the CFG business into their consolidated accounts, that's all. Dividend payment would depend on cash flow requirements and not solely on earnings alone.

Hope this explanation helps, cheers !

fishman said...

Long awaited post! Like to share some of my thoughts here!

I think increasing revenue is applauble, but I think a company that's able to decrease COGS while increasing or at least mantaining sales is even better! BUT THEN again, if management tries to decrease COGS by buying in cheap and poor quality goods hoping to pass over to customers (i.e unethical practices) to make a quick buck. Surely these companies can't possibly survive long too...

So I think these numbers and ratios really need to be analyzed carefully and in context. Best solution I can think of to avoid the above stated problem would be to see that the numbers show a certain trend, years after years under a stable and consistent mangement.

Ivan mentioned about looking out for future expansion plans as criteria, I totally agree with that. But then again (Hmmm second time!), how to guage whether such plans will work out as planned and expected? Worse, will I be paying too much in anticipation of such promises? That's something I can't seem to figure out for now, i.e how do I know that such plans will work or be a flop?

musicwhiz said...

Hi fishman,

Thanks a lot for your comments. Yes, I agree that keeping revenues constant while decreasing COGS is also a good way to boost gross profit and GP margin; but this will imply that the company isn't growing the scale of their business or that prices may be stagnant or decreasing even with an increase in sales volume. Long-term wise, this will not bode well for the company.

I think a 5-year trend is usually good to review how the company has been consistently performing over the years. Assuming there are no big changes to Management, this is the litmus test which will set apart the men from the boys.

Expansion plans are important too, as Ivan mentioned; but one has to ensure that expansion does not come at the cost of declining cash flows and lower ROE/IRR. The way to gauge if such plans are executed well is to see if there is any earnings accretion. Also, is there any boost to ROE or EPS as a direct result of those plans, and how much of it is sustainable going into the future.

Benson said...

Hi ,

See u in PAH thread and not long ago in this blog for rights subscription.
Thank you for yr insightful in biz world. I m not financially savvy but willing to learn so as to protect my investments.
Missed yr part 1 to 4 in yr research series and wondering to access them? or would you pm me in CNA forum as roookie68 or my email ?

Thanks a lot. Cheers and happy investing.

musicwhiz said...

Hello Benson,

You're most welcome. Glad that my blog is helpful to readers in understanding issues pertaining to the biz world.

You can access Part 1 and all other parts by clciking on the archives located at the right-hand sidebar. You can try either June or July 2007 archives, I think it should still be there. :)

Cheers too and good luck for your investments !