How to analyse financial statements?

The basic understanding of financial statements is a pre-condition to performing financial analysis. It can start from a basic analysis and then expand into complex financial analysis.

How to analyse financial statements

Step 1: Operating margins

Operating Margin = Operating Profit / Net Sales

The operating profit = revenue - cost of goods sold (COGS) - operating expenses - depreciation - amortization.

Operating profit is also called Earnings Before Interest and Taxes (EBIT).

The trend must be seen over a period of 10 years to understand the trend. If the operating profit margin is low, it is an indicator that operating costs are too high and operating profit is low. It may also indicate that a minor change in demand may result in erosion of current profitability.

Step 2: ROE

Looking at operating margin is easy; many websites provide operating margin directly. The next step is to calculate RoE, Return on Equity.

Return on equity is a great overall measure of a company’s profitability because it measures the efficiency with which a company uses shareholders’ equity.

RoE = Net margin × Asset turnover × Financial leverage

RoE = (Net Profit / Net Sales) × (Net Sales / Total Assets) × (Total Assets / Shareholder’s Equity)

Net margin is net income divided by sales, and it tells us how much of each rupee of sales a company keeps as earnings after paying all the costs of doing business.

Asset turnover is sales divided by total assets, which tells us roughly how efficient a firm is at generating revenue from each rupee of assets.

Financial leverage is essentially a measure of how much debt a company carries, relative to shareholders’ equity.

Be careful of a high financial leverage ratio if a company’s business is cyclical or volatile.

Leverage on its own is not good or bad, it must be seen in the context of margin and asset turnover.

If you can find a company with the potential for consistent ROEs over 20%, there’s a good chance you are in for a high ride.

Step 3: ROIC

RoE calculated the common equity shareholder’s return. However, a company may source capital using debt as well. Return on Invested Capital (ROIC) helps in addressing this issue.

A high-ROIC company typically creates more value by focusing on growth, while a lower-ROIC company creates more value by increasing ROIC.

A loss-making company or a negative ROIC company, growing its sales will only increase losses. So, the growth will be detrimental.

ROIC = NOPLAT / Invested Capital

This calculation is complex and would need a fair understanding of accounting. Each item i.e. NOPLAT (net operating profit less adjusted taxes) and Invested capital is broken down into subparts.

The evaluation of a business’ operating efficiency using NOPLAT is not impacted by how much leverage the company has or how much loans it has on its balance sheet given that debt servicing, that is, the interest used to finance debt, negatively impacts a firm’s bottom line and, thus, decreases its tax expense.

Return on invested capital (ROIC) is used to gauge how well a company allocates capital to profitable activities. This is done using funds allocated towards working capital and other operating assets.

A consistent ROIC of over 20% indicates high quality. You must understand how sustainable ROIC is, this can be done by looking at the breakup of ROIC.

Cost structure and profitability analysis is done using NOPLAT breakup.

Whereas how efficiently assets are used comes from the invested capital breakup.

Asian paints NOPLAT margin is maintained between 14-19%, whereas capital efficiency is reducing with more funds getting allocated towards working capital and plant, property, and equipment.

The next step will be to understand why the allocation is increasing and how much profitability the company can generate due to this investment.

Start your analysis from operating margins, move to ROE and then to ROIC.

Basics of financial statements

"The primary goal in financial reporting is the dissemination of financial statements that accurately measure the profitability and financial condition of a company." ~ Howard Schilit

Basics of financial statements

What are financial statements?

Financial statements are reports issued by companies to convey information about their financial health and recent results.

Why do we financial statements?

Every firm needs to be able to organize the financial information related to its business.

A firm must know how much of a product it was able to sell, how much it cost to produce the product and how much money it has in the bank.

Financial statements focus on the three main statements income statement, balance sheet and cash flow.

These reports aim to allow externals like banks and investors to get an idea of your business, how much sales you had, was the company profitable and how was it financed.

The set of financial reports or financial statements enable outsiders to gain an understanding of the company's business, about how many sales the company made this year, about how many sales the company had last year, and they also show how profitable the company's business was and what kind of costs it sustained.

Financial reports also show what a company owns and what it owes, how much cash was available in the company's bank accounts at the time of preparation of the report and so on.

Financial statements allow people who are outside an organization to make a reasonable judgment about its business. 

Financial Accounting revolves around three main statements: the income statement (also known as profit & loss or simply P&L), the balance sheet, and the Cash Flow statement.

Each one serves a different purpose and contains important information about how a business is running.

The Income Statement answers the question: How did the company perform throughout the period under consideration? Did it produce a profit or a loss?

Typically, an income statement is prepared for 1 year, but sometimes larger companies present it every quarter as well. The P&L statement helps us understand whether the operations of the firm created economic value.

The balance sheet answers the questions: What does a company owe and own on a certain date and what is the company's financial position?

It shows the assets that the business controls, the liabilities that it owes, and the amount of equity that belongs to equity holders. The reason why it is called a Balance Sheet is because total assets must equal liabilities plus shareholders' equity. 

A = L + E

The statement of Cash Flows answers the question: How much cash did the company make during the period under consideration and where did it come from?

During the course, you will know why we need a cash flow statement along with the income statement and balance sheet.

Income Statement

What is a revenue?

Revenue is also called net sales. We explained this in the previous module:

Revenue = Price X Units Sold

Revenue represents the inflow of funds received or to be received. Usually, the main revenue for a firm is its day-to-day sales customers buying goods that the firm sells. There can be other sources of revenue.

However, there can also be revenue from other sources say the automobile company renting out their building. In this case, we can say that the rent is not core to their operations. Selling cars and bikes and the associated service charge is core to their business but rent out buildings is a non-core activity.

How will you classify ‘rental income’ for a real estate company?

Renting buildings is a core activity for a real estate company and hence rental income is classified as Revenue.

When we talk about revenues and we want to categorize them, we must ask one fundamental question is this a type of revenue that is part of the firm's core business?

Why do we care about this distinction? When someone values a business, they are mainly interested in its core activities. That is why this distinction is important.

The sum of revenue and other revenue equals total revenue.

What are the different costs?

Now that we have talked about revenue, let’s look at costs. 

The most common expenses are the cost of goods sold, selling general and administrative costs depreciation and amortization interest expenses and taxes.

Cost of goods sold (COGS) are expenses necessary to produce the goods, the firm sells. The expenses that are directly attributable to the production of goods later sold are registered as costs of goods sold.

Please remember that COGS include the cost of materials used to create the goods and the amount we've paid to personnel directly involved with the production of the goods.

The difference between total revenues and cost of goods sold is called gross profit. This is the profit a company makes after deducting the costs associated with producing its products.

Gross profit is one of the most important financial indicators for a business gross profit directly shows us how much our business makes from its core activity.

Next, we will have the other large category of costs - selling general and administrative expenses also known as operating expenses. This is where an automobile company classifies its expenses for advertising expenses, salaries to staff, office rent, utility bills etc.

When we subtract COGS and SGA expenses from total revenues will obtain EBITDA (earnings before interest tax depreciation and amortization).

EBITDA is one of the most popular measures of operating income. It shows us how much we've made once we consider both direct and indirect expenses depreciation and amortization are two accounts that reflect the use of tangible and intangible assets.

Depreciation refers to assets of a physical nature while amortization is the term used for intangible assets.

Every year the plants that are used to manufacture cars/bikes become one year older therefore their value is reduced to account for such reduction.

Interest expenses are a cost a company bears for receiving financing. Typically, firms receive bank loans and pay interest expenses for the amounts they owe.

And finally, we have taxes.

Every firm pays corporate taxes that are proportional to the pre-tax profit it generates, the rules according to which pre-tax income generated by the firm is measured may vary depending on the country where the company operates.  

Once all expenses are considered we arrive at the bottom line which is called net income. This is the excess of revenues over expenses.

Balance Sheet

A balance sheet is a statement that shows what a company owns and owes every balance sheet has two sides on one side are the firm's assets what the company owns and on the other side the company's liabilities and equity what the company owes. 

Assets

The cash account is one of the most important drivers for business. It shows how much of the firm's assets are cash or can easily be converted into cash. We know that a business cannot function properly if sufficient cash is not available for its day-to-day operations.

When customers buy our products, they must pay for them. For the customer who plans to pay later, that amount would appear in accounts receivable which indicates the money owed by customers. These are payments from customers that are yet to be received.

Inventory is the account that shows the value of raw materials goods in the process of elaboration and finished goods ready to be shipped to customers. The company has these goods in its warehouse in production facilities or stores finished goods our products are ready to be sold to customers while raw materials and work-in-progress goods require additional processing raw materials are the basic components, we need to create the products and work in progress.

PP&E is typically made of assets such as land and buildings, cars, other vehicles, furniture, office equipment, computers, plant and machinery and so on.  

Current assets can be converted into cash easily whereas non-current are long-term assets.

Liabilities

Accounts Payable are one of the most important items on the liability side. When a company buys raw materials for its production process it registers the amount in accounts payable until the actual payment has been made. The firm owes its supplier an amount of money because it received the goods.

Financial liability appears on the balance sheet of a company when it receives external financing which is usually a bank loan. Financial liability may also occur for payments to government authorities, eg. income tax department.

A provision represents a payment we expect to make at a certain point in time. An example of a situation when we must set aside a provision is when a firm provides a warranty and can reasonably assume a certain level of expense based on experience. 

Current liabilities are expected to be paid in 12 months while noncurrent liabilities must be paid after 12 months.  For example, in a 5-year loan from a bank, the portion of the interest due in 1 year is the current portion of liability while interest and principal payment due after one year is non-current.

Shareholder's equity

On the same side of liabilities, we have ownership claims this is the capital the firm technically owes to shareholders.

Typically, we would have paid in capital by shareholders. The firm's starting capital and any money that comes in later if shareholders decide to increase capital retained earnings. These are the profits that have not been distributed as dividends and the firm has accumulated as equity.

Let’s take an example now to understand some of these transactions.

You plan to set up a coffee shop and expect to grow it big. You have Rs 10,000 to start your operations and this money is provided by your bank as a loan.

Borrows Rs 10,000 from bank

Assets                         Before                         Change                        After

Cash                            0                                  +Rs 10,000                  Rs 10,000

Liabilities                    Before                         Change                        After

Long-term debt           0                                  +Rs 10,000                  Rs 10,000

Now, you spend Rs 7,000 on coffee machines and cups. Then you buy Rs 2,000 worth of coffee beans and milk. You keep the remaining Rs 1,000 for making change and such.

Assets                         Before                         Change                        After

Cash                            0                                  -Rs 9,000                     Rs 1,000

Inventories                  0                                  +Rs 2,000                    Rs 2,000

PP&E                           0                                  +Rs 7,000                    Rs 7,000

Liabilities                    Before                         Change                        After

Long-term debt           0                                  +Rs 10,000                  Rs 10,000

You have spent Rs 9,000 (Rs 7,000 for coffee machine/cups and Rs 2,000 for ingredients), but that money hasn’t disappeared—it’s turned into assets and inventory.

The Rs 7,000 you spent on coffee machines & cups is “property, plant, and equipment (PP&E)” while the Rs 2,000 on coffee beans and milk is  “inventory”.

Assets

Cash                                        Rs 1,000

+ Accounts Receivable Rs 0

+ Inventory                              Rs 2,000

+ PP&E                                    Rs 7,000

Total Assets                             Rs 10,000

Liabilities

Accounts Payable                    Rs 0

Long-term Debt                      Rs 10,000

Equity

Retained Earnings                   Rs 0

Total liabilities & Equity          Rs 10,000

You open for business and sell 30 cups at Rs 100 a cup within the first two hours. By noon, half the milk and coffee beans are gone, so your “cost of goods sold” is Rs 1,000 or half of the Rs 2,000 you spent to buy supplies. Out of 30, seven people didn’t have any cash, so you let them buy on credit—which means you need to record Rs 7 X 100 = Rs 700 in accounts receivable, which is the money that folks owe to you.

Sell 30 cups at Rs 100 a cup (Rs 1,000 worth of inventory), with Rs 700 worth being sold on credit (cash not received yet)

Assets                         Before                         Change                        After

Cash                            Rs 1,000                      +Rs 2,300                    Rs 3,300

Accounts receivable    0                                  +Rs 700                       Rs 700

Inventory                    Rs 2,000                      -Rs 1,000                     Rs 1,000

PP&E                           0                                  +Rs 7,000                    Rs 7,000

In the middle of the day, you run out of milk, so you run over to the corner grocery store to buy more. But when you arrive, you realize that you left your money back at the stand, so you promise the grocer you will come back on Sunday i.e. after 6 days. We post Rs 500 to accounts payable, which is money that you owe to the grocery store for the milk. (Think of accounts payable like your credit card. If you buy a shirt on your credit card, you can use it right away—but you still owe the credit card issuer some cash.)

Buy Rs 500 worth of milk on credit

Assets                         Before                         Change                        After

Cash                            Rs 3,300                      0                                  Rs 3,300

Accounts receivable    Rs 700                         0                                  Rs 700

Inventory                    Rs 1,000                      +Rs 500                       Rs 1,500

Liabilities                    Before                         Change                        After

Accounts Payable        0                                  +Rs 500                       Rs 500

At the end of the first day, you realize that your coffee machine is taking longer time than usual. The accounting name for this wear-and-tear is depreciation, which lets you record the fact that your equipment isn’t as productive as it used to be.

(In the real world, depreciation isn’t recorded at the moment something starts wearing out. It’s a regular charge that assumes that an asset wears out over a set period—as long as forty years for a building, and as short as three years for a computer)

Depreciation is a cost of doing business, just like buying coffee beans and milk, because you will eventually have to buy a new coffee machine if you stay in the business. Because all costs have to be recorded, we post Rs 100 for depreciation.

Record wear and tear on the coffee machine

Assets                         Before                         Change                        After

PP&E                           Rs 7,000                      -Rs 100                        Rs 6,900

After a long day of serving coffee, your balance sheet and income statement will look like this.

Assets                                      Original                       Final

Cash                                        Rs 1,000                      Rs 3,300

+ Accounts Receivable  Rs 0                             Rs 700

+ Inventory                              Rs 2,000                      Rs 1,500         

+ PP&E                                    Rs 7,000                      Rs 6,900

Total Assets                             Rs 10,000                    Rs 12,400

Liabilities

Accounts Payable                    Rs 0                             Rs 500

Long-term Debt                      Rs 10,000                    Rs 10,000

Equity

Retained Earnings                   Rs 0                             Rs 1,900         

Total liabilities & Equity          Rs 10,000                    Rs 12,400

Sales                            Rs 3,000

(-) COGS                      Rs 1,000

(-) Depreciation           Rs 100

Net Profit                    Rs 1,900

Notice that your net profit is Rs 1900 but your cash account went up by Rs 2,300. Why the difference?  

To understand how much cash your little business generated, we start with his Rs 1900 in net profits, which is the difference between what you paid for ingredients, and what you received in payment for each cup of coffee.

But to arrive at the cash profits, we first need to add back the Rs 100 in depreciation. You see, although we need to keep track of the expense that you incurred by partially wearing out your coffee machine — remember, accounting is all about keeping score—you didn’t have to pay out Rs100 in cash to cover the wear and tear. You will have to replace the coffee machine eventually.

This is the critical difference between accounting profits and cash profits—accounting profits match revenues with expenses as closely as possible, whereas cash profits measure only the actual cash flowing into and out of a business.

Next, we need to take into account the fact that you used up half your original inventory of milk, as well as the fact that you went out and bought an additional Rs 500 worth of milk.

Your inventory went from Rs 2000, to Rs 1000, and back to Rs 1500. This net decrease in inventory from Rs 2000 to Rs 1500 is a source of cash. In other words, you had Rs 2000 of capital tied up in inventory at the start of the business, but now you have only Rs 1500 of capital invested in inventory. As a result, you converted Rs 500 in inventory to Rs 500 in cash.

However, you are also owed Rs 700 by coffee cup consumers who haven’t paid you yet. Because you had to pay to produce the coffee they consumed and they haven’t yet given you any cash. In other words, you paid out cash to get the ingredients you needed to make cups of coffee, but you have not yet received any cash in return, so your decision to extend credit used up to Rs 700 in cash.

Finally, let’s not forget that you are a beneficiary of credit because you still owe the grocer Rs 500 for the extra milk you bought. Because you received something without paying out cash for it, your cash account increases by Rs 500.

We can follow the trail from your Rs 1900 in net profits to Rs 2300 in cash flow with this simple table:



Net profits = Rs 1900

+ Rs 100 depreciation

+ Rs 1000 inventory (coffee cups sold: Rs 3,300 – Rs 2,300)

– Rs 500 inventory (extra milk purchased)

− Rs 700 accounts receivable (money owed to you)

+ Rs 500 accounts payable (money owed by you)

= Rs 2300 in operating cash flow

The key takeaway here is that the income statement and cash flow statement can tell different stories about a business because they’re constructed using different sets of rules.

The income statement strives to match revenues and expenses as closely as possible. But the cash flow statement cares only about the CASH that goes in and out the door, regardless of the timing of the actions that generate cash.

Cash Flow Statement

P&L and Balance sheets are based on accrual accounting whereas cash flow statement is based on actuals.

Accrual accounting ensures that a firm records its economic operations in the period when they have been carried out. In other words, revenue is recorded when it is earned and costs are registered when they are incurred a company's income statement will contain revenues related to products or services that have been transferred or delivered to the client regardless of when cash is received in the same way. Costs will be registered in the period when they have been sustained and not in the period when they have been paid.

Cash flow generation and liquidity are vital to all businesses. A company must be able to measure the actual amount of money it makes and estimate its future capital needs the cash flow statement identifies how much cash is coming in and going out and points out where the cash is generated or spent.

We have three types of cash flow:

1. Cash flow from operating activities consists of cash transactions affecting a firm's net income.

2. Cash flow from investment activities resulting from investments in fixed assets and other long-term investments.

3. Cash flow from financing activities made of transactions that affect a company's capital structure.

A company's net cash flow is equal to the difference between the amount of cash that was registered in the current period and the amount of cash that was observed in the previous period.

P&L is an estimate of profitability whereas a cash flow statement is cash movement. There is a major advantage to focusing on the cash flow statement since CASH is king.

All these statements are found in an annual report. An annual report also includes a chairman letter explaining how the year went by, a management discussion section explaining business headwinds/tailwinds, CSR activities and audit reports.

Since financial statements are an estimate of the performance of a company, they may include many assumptions and should be seen with scepticism. Irrespective, an annual report should still be the starting point of knowing a company.  

How to evaluate competitive advantage

The competitive advantages will eventually be copied away or the tastes and preferences of consumers will change and companies will become irrelevant. But a few generate enormous wealth during their lifetime.

How to evaluate competitive advantage

The key to investing is determining the competitive advantage of any given company and, above all, the durability of that advantage. The products or services that have wide, sustainable moats around them are the ones that deliver rewards to investors. – Warren Buffet

To understand competitive advantage you need to follow a few steps.

1.     Evaluate a company's historical profitability.

This can be done using profitability ratios i.e. RoE and RoA.

RoE of more than 15% p.a. over 10 years and RoA of more than 6% p.a. over 10 years will indicate that the company has some competitive advantage.

If you understand financial analysis deeply, return on investment capital is a very good matrix.

2.     Understand what is the source of its profitability.

Why is the company able to earn well and why competition is not taking away its profitability?

3.     How long the company can continue to be profitable?

Understand how sustainable is the competitive advantage.

4.     Analyse the industry’s competitive landscape.

If there are Only 2 or 3 players in the industry usually those industries are better in terms of growth.

In case the company is in an industry which is crowded with many competing with each other, usually the industry will suffer from low return on investment.

Over the long term, it's hard for a stock to earn a much better return than the business which underlies it earns. If the business earns 6% on capital over forty years and you hold it for that forty years, you're not going to make much different than 6% return - even if you originally buy it at a huge discount. Conversely, if a business earns 18% on capital over 20 or 30 years, even if you pay an expensive looking price, you'll end up with one hell of a result. – Charlie Munger

Sources of competitive advantage

1.     Creating real product differentiation through superior technology or features.

In the case of Apple, the iPhone and the iOS system is far superior to their closest competitor. Asian paint has more than 60% of India’s paint market share and has similar paint in comparison with the competitor, but their supply chain is the best in the world.

2.     Creating perceived product differentiation through a brand or reputation.

Coca-Cola and Pepsi enjoy a certain reputation that even when you are travelling outside India there is trust in the brand and you do not doubt the quality of its constituents. You may order a local beer but you would be reluctant to order a local aerated beverage.

3.     Driving costs down and offering a similar product or service at a lower price.

The cost advantages can be driven through better processes. A better process will ensure costs are managed at a lower level and they are sustained at a low level and these structures may be difficult for the competitors to copy.

The other more sustainable cost advantage comes through the scale. If an industry requires heavy investment not everyone can be part of that industry. Usually, the largest player in the market takes a massive market share and the fixed cost gets spread out over large volumes.

4.     Customer lock-in

Areas where the company may have customer lock-in advantage.

• The company has an advantage if the company has to provide a significant amount of client training.

• If the product is mission-critical, switching can be disastrous to the main product.

• If the product is an industry standard and consumers expect the company to use the industry standards products only.  

• If the benefit of switching is too small and the pain is more.

• A company locks in customers when the company tends to sign long-term contracts.

5.     Keeping the competition on bay

An easy one is to get regulatory protection. The other option is patenting, although patents can be challenged and may not always provide a competitive advantage due to being copied away.

The next strategy is the network effect. Throughout the world people use Microsoft Excel for work. One of the reasons for this is both sides of users use the same product so that there is a common way of doing work.

These competitive advantages will eventually be copied away or the tastes and preferences of consumers will change and companies will become irrelevant.

Management that is always on the lookout to understand how they can improve their product or services and take necessary course correction, will be at an advantage to sustain these competitive advantages.

A smart analyst will be able to have some sense of figuring out when the competitive advantages are fading away. Watch out for a fall in operating margins over the last few quarters.