What Is A Financial Statement ? Part 2 of 2

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Profitability

1. Gross Margin

Definition

Gross Margin is the percentage of Gross Profit out of sales or Revenue.

Gross Margin (A: Dec. 2013 ) = Gross Profit (A: Dec. 2013 ) / Revenue (A: Dec. 2013 )

= (Revenue – Cost of Goods Sold) / Revenue

= (204.71 – 40.471) / 204.71 = 164.2 / 204.71

= 80.23 %

A positive Gross Profit is only the first step for a company to make a net profit. The gross profit needs to be big enough to also cover related labor, equipment, rental, marketing/advertising, research and development and a lot of other costs in selling the products.

Explanation

Warren Buffett believes that firms with excellent long term economics tend to have consistently higher margins.Durable competitive advantage creates a high Gross Margin because of the freedom to price in excess of cost. Companies can be categorized by their Gross Margin

  1. Greater than 40% = Durable competitive advantage
  2. Less than 40% = Competition eroding margins
  3. Less than 20% = no sustainable competitive advantage
    Consistency of Gross Margin is key

Be Aware

If a company loses its competitive advantages, usually its gross margin declines well before its sales declines. Watching Gross Margin and Operating Margin closely helps avoid value trap situations.

Net Margin

Definition

Net margin – also known as net profit margin is the ratio of Net Income divided by net sales or Revenue, usually presented in percent.

Net Margin = Net Income (A: Dec. 2013 ) / Revenue (A: Dec. 2013 )

  • 274 / 204.71 = 28.96 %

Explanation

Although Net Income and Earnings-per-Share (EPS) are the most widely used parameter in measuring a companys profitability and valuation, it is the least reliable. The reason is that reported earnings can be manipulated easily by adjusting any numbers such as Depreciation, Depletion and Amotorization and non-recurring items.

But the long term trend of the net margin is a good indicator of the competitiveness and health of the business.

 

2. Operating Margin

Definition

Operating margin – also known as operating income margin, operating profit margin and return on sales (ROS) – is the ratio of Operating Income divided by net sales or Revenue, usually presented in percent.

Operating Margin = Operating Income (A: Dec. 2013 ) / Revenue (A: Dec. 2013 )

  • 006 / 204.71 = 36.64 %

Explanation

Just like Gross Margin, it is important to see a company maintains its operating margin over time. Among the same industry, a company with higher operating margin is more efficient in its operation. It is also more stable during industry slowdown or recessions. Peter Lynch prefers those with higher margins than those with lower margins.

 Be Aware

Compared with a companys EBITDA margin, Operating Margin can be manipulated by adjusting the rate of depreciation, depletion and amortization (DDA). If a company is facing competition, its Operating Margin may decline.

Often the Operating Margin declines well before the companys revenue or even profit decline. Therefore, Operating Margin is a very important indicator of whether the company is facing problems.

For instance, by 2012, Nokia (NOK)s problems were well known and its stock had lost more than 90% of its market value since 2007. But Nokias Operating Margin had already been in decline since 2002, although its earnings per share were still rising. Investors who paid attention to Operating Margin would have avoided this huge loss. The same can be said for Research-in-Motion (RIMM). Therefore, Operating Margin is a very important screening filter for GuruFocus. GuruFocuss Buffett-Munger screener requires that the profit margin is either consistent or expanding. The Model Portfolio of the Buffett-Munger screener has outperformed the market every year since inception in 2009.

 

3. Peter Lynch Fair Value

Definition

Peter Lynch Fair Value = PEG *          5-Year EBITDA Growth Rate * Earnings Per Share (NRI) (TTM)

  • 1 * 11.96 * 1.62 = 19.38

Ebix Inc’s Earnings Per Share (NRI) for the trailing twelve months (TTM) ended in Sep. 2014 was 0.4 (Dec. 2013 ) + 0.4 (Mar. 2014 ) + 0.35 (Jun. 2014 ) + 0.47 (Sep. 2014 ) = $1.62.

If 5-Year Earnings Growth Rate is greater than 25% a year, we use 25.

Please note that we use the 5-year average growth rate of EBITDA per share as the growth rate. EBITDA growth is subject to less manipulations than net earnings per share. In the calculation, PEG=1 because Peter Lynch thinks that the fair P/E ratio of the growth stock is equal to its earnings growth rate.

Explanation

Peter Lynch Fair Value applies to growing companies. The ideal range for the growth rate is between 10 – 20% a year.

Peter Lynch thinks that the fair P/E value for a growth company equals its growth rate, that is PEG = 1. The earnings here is trailing twelve month (TTM) earnings. The growth rate we use is the average growth rate for earnings per share over the past 5 years.

Please don’t confuse Peter Lynch Fair Value with the value reached in Peter Lynch Chart. In Peter Lynch chart, a fixed P/E ratio of 15 is used to draw the Earnings Line. Therefore the value reached has a P/E ratio of 15. But in Peter Lynch Fair Value calculation, P/E equals to the growth rate of EBITDA over the past 5 years, which is 11.96 instead of 15 in this case.

 

Income Statement

 

1.EPS (Basic)

Definition

PS (Basic) is a rough measurement of the amount of a company’s profit that can be allocated to one share of its stock. Basic earnings per share (EPS) do not factor in the dilutive effects on convertible securities.

Basic EPS (A: Dec. 2013 ) = (Net Income – Preferred Dividends) / Total Shares Outstanding

  • 274 – 0) / 37.588 = 1.58

Explanation

EPS is the single most important variable used by Wall Street in determining the earnings power of a company. But investors need to be aware that Earnings per Share can be easily manipulated by adjusting depreciation and amortization rate or non-recurring items. That’s why GuruFocus lists Earnings per share without Non-Recurring Items, which better reflects the company’s underlying performance.

Be Aware

Compared with Earnings per share, a companys cash flow is better indicator of the companys earnings power.

If a companys earnings per share is less than cash flow per share over long term, investors need to be cautious and find out why.

 

2. Net Income

Definition

Definition

Net Income is the net profit that a company earns after deducting all costs and losses including cost of goods, SGA, DDA, interest expenses, non-recurring items and tax.

Net Income = Revenue – Cost of Goods Sold – Selling, General, & Admin. Expense – Research & Development – Depreciation, Depletion & Amortization – Interest Expense – Non-Recurring Items (NRI) – Tax Expense + Others
= Earnings Before Depreciation and Amortization – Depreciation, Depletion & Amortization – Interest Expense – Non-Recurring Items (NRI) – Tax Expense + Others
= Operating Income – Interest Expense – Non-Recurring Items (NRI) – Tax Expense + Others
= Pre-Tax Income – Tax Expense + Others

Explanation

Net income is the most widely cited number in reporting a companys profitability. It is linked to the most popular earnings-per-share (EPS) number through:

Earnings Per Share (Q: Sep. 2014 ) = (Net Income – Preferred Dividends) / Total Shares Outstanding

  • (18.015 – 0) / 38.253 = 0.47

Although Net Income and Earnings-per-Share (EPS) are the most widely used parameter in measuring a company’s profitability and valuation, it is the least reliable. The reason is that reported earnings can be manipulated easily by adjusting any numbers such as Depreciation, Depletion and Amotorization and non-recurring items.

 

EPS is most useful for companies that have:

  • A predictable business
  • Consistent accounting methods
  • And few restructurings

The dividend paid to preferred stocks needs to be subtracted from the total net income in the calculation of EPS because common stock holders are not entitled to that part of the net income.

 

Be Aware

Warren Buffett looks for consistency and upward long term trend. Because of share repurchase it is possible for net earnings trend to differ from EPS trend. He preferred net income over EPS. The companies with durable competitive advantage companies report higher % net earnings to total revenues.

Important: If a company is showing net earnings history greater than 20% on total revenues, it is probably benefiting from a long term competitive advantage.

If net earnings is less than 10%, likely to be in a highly competitive business.

 

3. Operating Income

Definition

Operating income, sometimes also called Earnings Before Interest and Taxes (EBIT), is the profit a company earned through operations. All expenses, including cash expenses such as cost of goods sold (COGS), research & development, wages, and non-cash expenses, such as depreciation, depletion and amortization, have been deducted from the sales.

Be Aware

Compared with a companys EBITDA margin, Operating Margin can be manipulated by adjusting the rate of depreciation, depletion and amortization (DDA).

If a company is facing competition, its Operating Margin may decline. Often the Operating Margin declines well before the companys revenue or even profit decline. Therefore, Operating Margin is a very important indicator of whether the company is facing problems.

For instance, by 2012, Nokia (NOK)’s problems were well known and its stock had lost more than 90% of its market value since 2007. But Nokias Operating Margin had already been in decline since 2002, although its earnings per share were still rising. Investors who paid attention to Operating Margin would have avoided this huge loss. The same can be said for Research-in-Motion (RIMM).

 

4. Revenue

Definition

Also referred as sales, revenue is income that a company receives from its normal business activities, usually from the sale of goods and services to customers. Revenue is often referred to as the “top line” due to its position on the income statement at the very top.

Explanation

In ranking the predictability, companies with more consistent revenue and earnings growth are ranked high with predictability.

Peter Lynch categorized companies according to their revenue growth:

  • Slow Grower: Inflation < 10-Year Revenue Growth Rate < 10%:
  • Stalwart: 10% < 10-Year Revenue Growth Rate < 20%:
  • Fast Grower: 10-Year Revenue Growth Rate > 20%:

His favorite companies are stalwart, those growing between 10-20% a year.

Companies in cyclical industries may see their revenue fluctuate wildly in good years and bad years.

 

Be Aware

Revenue can be manipulated by changing the way how revenue is booked. Companies may book sales before the payment is received, or before the revenue is fully earned. These will be added to balance sheet items such as account payable or account receivables.

 

Balance Sheet

1.Intangible Assets

Definition

Intangible assets are defined as identifiable non-monetary assets that cannot be seen, touched or physically measured. Examples of intangible assets include trade secrets, copyrights, patents, trademarks. If a company acquires assets at the prices above the book value, it may carry goodwill on its balance sheet. Goodwill reflects the difference between the price the company paid and the book value of the assets.

 

Explanation

If a company (company A) received a patent through their own work, though it has value, it does not show up on its balance sheet as an intangible asset. However, if company A sells this patent to company B, it will show up on company B’s balance sheet as an intangible asset.

The same applies to brand names, trade secrets etc. For instance, Coca-Cola’s brand is extremely valuable, but the brand does not appear on its balance sheet, because the brand was never acquired.

 

Some intangibles are amortized. Amortization is the depreciation of intangible assets.

Many intangibles are not amortized. They may still be written down when the company decides the asset is impaired.

 

Whenever you see an increase in goodwill over a number of years, you can assume its because the company is out buying other businesses above book value. GOOD if buying businesses with durable competitive advantage.

 

If goodwill stays the same, the company when acquiring other companies is either paying less than book value or not acquiring. Businesses with moats never sell for less than book value.

Intangibles acquired are on balance sheet at fair value.

Internally developed brand names (Coke, Wrigleys, Band-Aid) however are not reflected on the balance sheet.

One of the reasons competitive advantage power can remain hidden for so long.

Be Aware

Companies may change the way intangible assets are amortized, and this will affect their reported earnings.

 

2. Long-Term Debt

Definition

Long-Term Debt is the debt due more than 12 months in the future. The debt can be owed to banks or bondholders. Some companies issue bonds to investors and pay interest on the bonds.

The interest paid on companies’ debt is reflected in the income statement as interest expense. If a company has too much debt and it cannot serve the interest payment on the debt or repay the matured debt, the company risks bankruptcy. Peter Lynch famously said: “A company that does not have debt cannot go bankrupt.”

A companys long term debt may have different dates of maturity and interest rates, depending on the terms.

Usually a company issues long term debt to pay for its capital expenditures. Borrowing allows the company to do things that otherwise cannot be done with only the capital it has. But debt can be risky.

 

Explanation

Long-Term Debt to Total Assets is a measurement representing the percentage of a corporation’s assets that are financed with loans and financial obligations lasting more than one year. The ratio provides a general measure of the financial position of a company, including its ability to meet financial requirements for outstanding loans. A year-over-year decrease in this metric would suggest the company is progressively becoming less dependent on debt to grow their business.

 

Long-Term Debt to Total Assets (Q: Sep. 2014 ) = Long-Term Debt (Q: Sep. 2014 ) / Total Assets (Q: Sep. 2014 )

  • 363 / 564.472 = 0.11

Buffett says that durable competitive advantages carry little to no LT debt because the company is so profitable that even expansions or acquisitions are self financed.

We are interested in long term debt load for the last ten years. If the ten years of operation show little to no long term debt, then the company has some kind of strong competitive advantage.

Warren Buffetts historic purchases indicate that on any given year, the company should have sufficient yearly net earnings to pay all long term within 3 or 4 year earnings period. (e.g. Coke + Moody s = 1yr)

Companies with enough earning power to pay long term debt in less than 3 or 4 years is a good candidate in our search for long term competitive advantage.

BUT, these companies are targets for leveraged buy outs, which saddles the business with long term debt.

If all else indicates the company has a moat, but it has ton of debt, a leveraged buyout may have created the debt. In these cases the companys bonds offer the better bet, in that the companys earnings power is focused on paying off the debt and not growth.

Important: little or no long term debt often means a Good Long Term Bet

 

Cash flow Statement

1.Cash flow from operations

Definition

Cash flow from operations refers to the cash brought in through a company’s normal business operations. It is the cash flow before any investment or financing activities. It is the cash version of net income.

Explanation

Cash flow from operations contains six items:

  1. Net Income From Continuing Operations:
    Net Income From Continuing Operations indicates the net income that a firm brings in from ongoing business activities. These activities are expected to continue into the next reporting period. It excludes extraordinary items, income from the cumulative effects of accounting changes, non-recurring items, income from tax loss carry forward, and preferred dividends.
  2. Depreciation, Depletion and Amortization:
    Depreciation is a present expense that accounts for the past cost of an asset that is now providing benefits.
    Depletion and amortization are synonyms for depreciation.
    Generally:
    • The term “depreciation” is used when discussing man made tangible assets
    • The term “depletion” is used when discussing natural tangible assets
    • The term “amortization” is used when discussing intangible assets
  3. Change In Working Capital:
    Working Capital is a measure of a company’s short term liquidity or its ability to cover short term liabilities. It is defined as the difference between a company’s current assets and current liabilities. Changes in Working Capital is reported in the cash flow statement since it is one of the major ways in which net income can differ from operating cash flow.
  4. Deferred Tax:
    It is the cash flow generated from deferred tax.
  5. Cash Flow from Discontinued Operations:
    Cash received by a company that comes from the sale of part of business.
  6. Cash Flow from Others:
    These are cash differences caused by the change of inventory, accounts payable, accounts receivable etc. For instance, if a company pays its suppliers slower, its cash position will build up faster. If a company receives payments from its customers slower, its account receivables will rise, and its cash position will grow more slowly (or even shrink).

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