A company’s financial statements consist of three separate statements:
- the profit and loss statement or the income statement (P&L)
- the balance sheet (BS)
- the cashflow statement (CF)
The balance sheet lists out what the company owns: its assets, what the company owes to other entities: its debt, and what is left after its assets are subtracted by its debt: the shareholders’ equity, or the book value.
The P&L statement starts with sales or revenue and deduct all sorts of cost from revenue until we arrive at net income, which ultimately goes into shareholders’ equity on the balance sheet.
The cashflow statement describes how cash has actually been received and deducted from the company, which is usually different from actual profit gained and loss incurred. It links the P&L to what has changed in the balance sheet. One major item that affects cashflow and income differently is depreciation. Depreciation is treated as a cost in the income statement, but it has no actual cashflow impact.
1. The profit and loss (P & L) statement or income statement
The Profit and Loss Statement describes how the company has done over the past period in terms of sales and profits on paper. The following is usually how the P & L is arranged:
1) Sales or Revenue
2) Cost of Goods Sold (COGS)
3) Selling, General and Administrative Expenses (SG&A)
4) Operating Income or Operating Profit
5) Interest Expense or Income
6) Recurring Income or Recurring Profit
7) Extraordinary Gain or Loss
8) Profit before Tax
9) Net Profit
The most important no. to look at is 4) Operating Profit (or EBIT: Earnings before interest and tax). This no. is basically the profit that the firm has booked after it has subtracted all relevant costs that are incurred in doing its business. Below operating profit, no.s are subjected to very serious manipulation and hence become seriously unreliable. (That doesn’t mean that the operating profit cannot be manipulated though, in fact, everything from Sales to Net Profit can be manipulated, that is why integrity of management is so important.)
1.1 COGS & SG&A
The Cost of Goods Sold (COGS) refers to the direct input costs that is incurred by the company. This would include raw material cost, labour cost, energy cost, depreciation cost etc.
One important measure of profitability comes in the form of Gross Profit which is Sales – COGS. It measures the direct profitability of the company after all the input costs are deducted.
Selling, General and Administrative (SG&A) refers to the indirect costs incurred when doing business. As the name suggests, these costs would usually be sales, marketing, administrative, logistics (could be classified under COGS as well though). A cost-conscious company is one that keeps its SG&A low. As a percentage of sales, SG&A varies from 10-40%.
Hence the total cost of the company would be COGS + SG&A, and whatever profits that remain would be the Operating Profit or EBIT (oh another acronym!). If a company has very low COGS + SG&A, it means that its OP margin is very high (40% or higher rocks!) and it is probably piling up cash and you should definitely dig further.
1.2 Net Profit
Net Profit has little to do with the company’s business because it measures a lot of “costs” that are progressively less relevant to the company’s core operations. To recap, we all know that the most relevant costs of any business operations will be
Cost of Goods Sold (COGS)
Sales, General and Administrative Expenses (SG&A)
The no. after these costs are subtracted is the Operating Profit (OP). After OP, interest expenses are deducted, because lenders take the first cut of what is left as they always do. Of course the some companies do not borrow, so they have interest income instead. The number after interest is accounted for is called by various names like Recurring Profit or Ordinary Profit or Earnings Before Tax and extraordinary items etc.
After this, we have extraordinary losses or gains .This is where companies hide all the bad stuff usually and you see extraordinary losses or gains every year, which makes you wonder if they are extraordinary or exactly ordinary.
After that, we have taxes and after taxes we finally come to Net Profit, which is profit that is attributable to the shareholders of the company. (If you think about it, shareholders are ranked behind 1. Customers 2. Workers, 3. Debt holders, 4. Disasters 5. the Taxman, which makes investors the lowest lifeform.) You must understand that at every level, no.s are subjected to manipulation and hence when it comes to Net Profit, this no. actually has no integrity left.
Nevertheless, when Net Profit is divided by the no. of shares outstanding (i.e. no. of shares issued by the company which is still in circulation), we get another big ticket no. called EPS, or earnings per share.
EPS is used to calculate the Price Earnings Ratio, or P/E ratio. And this ratio determines how cheap or expensive is the stock.
As a rule of thumb, Net Profit should be 50-70% of Operating Profit. This is worked below:
Assuming that a company has $100 in operating profit, then
Operating Profit $100
Recurring Profit $90 (say interest expense is 10% of OP)
No XO loss or gain as it should be
Tax rate 20% (i.e. tax is $18)
Net Profit $72
Hence a good co. would have a Net Profit of roughly 50-70% of OP, depending largely on the tax rate. In Singapore, however, there are a few companies that has Net Profit that is greater than Operating Profit. This is usually because they have a lot of profit gained after OP like sale of investment in stocks, properties or simply income from cash holdings.
The most prominent example is SPH. For several years, SPH sold various investments that it held in Singapore stocks like Starhub, M1 etc. These huge gains from investments are allocated at the Recurring Profit level and hence even after taxes are deducted, Net Profit is much higher than it should be, sometimes even higher than OP.
2. The balance sheet
The balance sheet balances because that is how it is defined. By definition,
Assets – Liabilities = Shareholders’ Equity
In the balance sheet, assets can also be broken down into current assets and non-current assets. Liabilities can be broken down into current liabilities and non-current liabilities. These sub-levels will consist of individual components that makes up the basic building of the balance sheet.
Assets
– Current Assets
Cash
Marketable securities or short-term investments
Accounts Receivables
Inventory
– Non-current Assets
Fixed Assets (Property, Plant and Equipment (PP&E)
Intangibles
Long-term investments
Liabilities
– Current Liabilities
Accounts payables
Short-term borrowing (short-term debt)
– Non-current Liabilities
Long-term borrowings (long-term debt)
Other long-term liabilities (pension liabilities, deferred tax liabilities etc)
Shareholders’ Equity
Paid-in capital
Retained earnings
2.1 Asset Turnover
Asset Turnover measures the revenue that can be generated by $1 of the firm’s asset. i.e. how much money can be made from $1 of asset. It is calculated by dividing Sales over Total Assets.
To increase the firm’s Asset Turnover while keeping Asset constant requires operational efficiency improvement. This cannot be done if the company is slack or has a lousy management.
Hence Asset Turnover may be useful only for historical comparison. If the Asset Turnover of a company has improved from 0.9x to 1.1x, you know that it has successfully generated more sales for every dollar of asset.
However Asset Turnover cannot be used for companies that does not generate its revenue from tangible assets. (e.g. online businesses with no assets to speak of.) In such cases, we have no choice but to return to more popular measures like ROE or OP margin
2.2 Fixed Asset and Depreciation
Fixed Asset refers to asset that are fixed. They include stuff like
1) Property, Plant and Equipment
2) Building and Structure
3) Furniture and Fixture
4) Land
Basically they are assets that are held by the company for its business operations and are not intended for sale and are held on for the long term.
Fixed assets are usually depreciated over 10-30 years to determine its cost impact on the business operation. The value of the fixed asset is then reduced by the amount that was depreciated.
2.3 Marketable and Investment Securities
Marketable and Investment Securities refer to stock holdings of the company. Marketable simply means the company has no intention in holding them for the long-term and would sell them when it’s appropriate. Investment securities are usually holdings of subsidiaries or affiliate co.s and the parent company has no intention of selling them.
Now because of accounting rules, these holdings may be accounted for at cost (i.e. at prices when the parent acquired them) or at market value 1 yr ago (i.e. when the book closed last yr). In some cases, the market value of these holdings may have grown to be quite significant, e.g. 50% of the parent’s market cap or more. Such cases would arise when the stock market enters a rally trend, or circumstances like acquisition offer or simply because the subsidiary grew so much faster than the parent.
So essentially when you buy the stock, you get a lot of “freebies” that comes along in its balance sheet. And investors love this kind of stuff. One good example would be Yamaha Corp, the musical instruments maker.
2.4 Cash and Debt
Perhaps the most important information that can be derived from analysing the balance sheet is whether the company has good financial health. This is determined by how much cash or debt the company holds.
A company that has no debt will be better than one that has. For a rough gauge, perhaps we can look at two simple ratios.
Net Debt to Equity ratio
Cash to Market Cap ratio
For a company that has debt, we first subtract cash from its debt to get its net debt level. Next we simply divide its net debt by its shareholders’ equity. E.g. Firm A has $100 Debt but $20 Cash and $80 Equity. Hence Net Debt to Equity = (100-20)/40 = 1. This means that Firm A employs as much debt as equity to finance its business. (Which is not very good)
In Singapore, a company with a Net Debt to Equity ratio of 1 or 100% is considered very bad since most listed companies here has no debt. This is especially true for the best companies around.
Now if the company has no debt, then how much cash is enough? The other ratio that people look at is the Cash to Market Cap ratio. This is simply taking cash that the company holds divided by its market capitalization. I would say that a ratio above 20% would be considered very good. This ratio rarely goes above 50% because if it does, essentially you are buying for the company’s operations at a 50% discount.
To illustrate further, imagine that a company has a Cash to Market Cap ratio of 100%. Essentially, you bought the company for free, because its cash would have paid you the amount you forked out, plus you get the company’s business which will continue to generate cashflow FOC.
3 The Cash Flow Statement
Cash flow measures the actual inflow and outflow of cash into and out of the firm. Hence while sales can be manipulated (e.g. by recognising sales from the future), a cash outflow is a cash outflow. When a cash outflow becomes a cash inflow, there are only two explanations:
1) This is fraud, the no.s are fake, don’t trust them
2) The money is going through the laundry
A company that has a poor cashflow is something to look out for. It is usually an early warning for bigger trouble to come. Avoid at all cost.
The cash flow statement is also further classified into three sub segments (whoa…a trilogy within a trilogy…)
1) The cash flow from operations or operating cash flow (CFO)
2) The cash flow from investments or investing cash flow (CFI)
3) The cash flow from financing or financing cash flow (CFF)
The most important no. to look out for is undoubtedly the operating cash flow (CFO)
This no. (i.e. CFO) measures the actual cash inflow from the firm’s core operations and it should always be a positive number. If it is not, it means the company cannot earn money from its core businesses and all alarms should sound and you should press the panic button and unload everything, if you own it, and avoid at all cost if you don’t.
3.1 Investing cash flow or CFI
Investing cash flow (or CFI) is usually the 2nd portion of the cash flow statement and it measures the money that the firm use for its investment activities. The most important no. here is the Capex no. Capex is the short form for Capital Expenditure. This is what the firm needs to invest in (usually in new equipment, new technology or new offices etc) in order to stay competitive in its business.
Other no.s that are quite boring that goes into investing cash flow as well will include:
1) Sale of Property, Plant and Equipment (opposite of capex)
2) Purchase and Sale of Investment Securities
3) Acquisition of new subsidiaries or associated companies etc
3.2 Financing cash flow or CFF
Financing cash flow (or CFF) is the last portion of the cash flow statement and it deals with the financing needs (both equity and debt) of the company. This would usually involve repayment of debt, or increase in borrowing, dividend payment, equity capital reduction, increase in equity, share buyback etc.
A firm needs capital to run its business. There are two ways to get capital,
1) you borrow from bank, this is call debt
2) you raise money from the stock market, this is call equity
Financing cashflow deals with what the firm does with its capital. Hence, it would be useful to observe how the company is changing its capital structure from this part of the statement.
In Singapore, a lot of companies are trying to reduce its equity base (SPH, Singpost etc) in order to make some financial ratios (like ROE) look good. However that is just part of the story, the other part is to return money back to their No.1 shareholder: Temasek Holdings. Of course, minority shareholders will stand to benefit as well, hence while it last, it would not be a bad idea to invest in these stocks.
3.3 Discounted Cash Flow or DCF
Discounted Cash Flow or DCF is basically adding up all the cashflow over the life of the firm and try to determine how much it is today.
Firm A will generate $1 of cashflow over the next 50 yrs, what is its value (or intrinsic value) today?
Well the simple answer is simply $1 x 50 = $50 (QED).
Now we must understand that $1 next year is not the same as $1 today. And $1 two years out is also different. The difference is due to interest.
So $1 next year is actually equal to $0.97 today because if we put $0.97 in the bank today, it will earn 3% interest and become $1 next year. And $1 two years out is roughly $0.93 today because if we put $0.93 into the bank today, it will earn 3% interest in 1 yr, and both the interest and principal after Year 1 will earn another 3% interest, which brings the total to $1 two years from now.
So once we calculated the present value of all those future $1 (50 of them), we add them all up and we get the intrinsic value of the firm. For the above example, the answer is $25.7.
Well, not so hard after all I guess. But the questions below will make you realize what makes it hard.
First, how the hell do we know if Firm A can actually earn $1 every year for the next 50 yrs? And what will the interest rate be in 50 yrs time? And why only 50 yrs, shouldn’t a company exist longer than that?
So that’s the hard part, for every input, there is some uncertainty. With DCF, you can have infinite no. of inputs, and that’s uncertainty times infinity. How fun. Personally I prefer to stick with PER and EPS estimates.
Company cheatsheet and stuff – not to be missed!
Company specific factors
Mkt cap greater than S$100mn
Operating Profit greater than S$10mn
OPM greater than 10%
Dividend yield greater than 4%
D/E Ratio less than 1x
Growth greater than 5%
ROE greater than 15%
ROA greater than 5%
Qualitative factors
Industry climate and firm’s position
Strengths and weaknesses of the firm
Major risks for the firm
Valuations
PER less than 18x
PBR less than 4x
EV/EBITDA less than 10x
There are a few things to take note. Even if a firm fails to meet 1 or 2 criteria, it doesn’t mean that the stock is lousy. If there are good reasons, it is still a buy. If you try to find a stock that meets everything, probably there won’t be any. That’s why the each criterion is actually not too strict to begin with. Also, qualitative info matters, that’s why it pays to read annual reports, research reports and business news.
Be $mart with Your Money 