If you’re going to try to ‘go it alone’ and invest in direct shares, rather than opting for exposure to the stock market via managed funds then you have to know how to read a financial statement. Understanding or misunderstanding financial statements can be the difference between big profits, and big losses!
Now, to really do a deep dive, there are 3 financial statements that need to be analysed – The Profit & Loss Statement, the Cashflow Statement, and the Balance sheet, however, lets start at the beginning and have a look at a P&L.
Example Consolidated P&L Statement – Retail Business
| 1. Revenue | $5,000,000 | |
| 2. Cost of Sales (COS) | $3,000,000 | |
| 3. Gross Profit (GP) | $2,000,000 | 40% |
| 4. Operating Expenses (OPEX) | ($1,500,000) | |
| 5. Earnings Before Interest, Tax, Depreciation & Amortisation (EBITDA) |
$500,000 | 15% |
| 6. Depreciation & Amortisation | ($100,000) | |
| 7. Earnings Before Interest & Tax (EBIT) | $400,000 | 8% |
| 8. Interest received | $20,000 | |
| 9. Interest Expense | ($50,000) | |
| 10. Profit Before Tax (PBT) | $370,000 | 7.4% |
| 11. Tax on earnings | $111,000 | |
| 12. Net Profit After Tax (NPAT) | $269,000 | 5.35% |
1. Revenue
Revenue is a company’s sales. It is important to note that revenue does not = cash received. In the accrual method of accounting, revenue is recognised at the time a sale is made (customer agrees, or contracts to accept the goods). However, a company may extend that customer payment terms – allowing them to pay for the goods 30, 60 or even 90 days later.
2. Cost of sales
Cost of sales is the direct costs of the products / services that a company is selling. In our example P&L above, our retailer has purchased $3M of stock from a supplier, and has sold that stock to customers for $5M.
3. Gross Profit.
Gross Profit (or G.P) is revenue less COS. GP expressed as a % of revenue is the GP Margin. In this case, 40%. Businesses with high GP margins have to sell less than businesses with low GP margins to make the same $ amount of GP. Consider the following example: Company B has to sell twice as much product to make the same GP because its margins are half that of company A. I know which company i’d rather own!
| Company A | Company B | |
| Revenue | $5,000,000 | $10,000,000 |
| GP Margin | 40% | 20% |
| Gross Profit (GP) | $2,000,000 | $2,000,000 |
4. Operating Expenses (OPEX)
Operating expenses are all the normal running costs of a business. Wages, rent, insurance, bank & merchant fees, accounting & legal costs, research & development, marketing etc etc.
5. Earnings Before Interest, Tax, Depreciation & Amortisation (EBITDA)
EBITDA represents a company’s profit if it had no debt, no cash in the bank, and no depreciation or amortisation due to large capital expenditure or business acquisitions – Essentially pre-tax profit from normal operations. EBITDA is an important accounting measure, as it reveals the underlying earning power of a businesses core operations. Consider if our example company above had $100,000,000 in the bank earning 5% interest. If that $5M in interest was added into the revenue line (as opposed be being accounted for after the EBITDA line), it would double revenue to $10M, and increase GP Margins to 70%… a whopping great cash balance would essentially mask what is otherwise a pretty mediocre business.
6. Depreciation & Amortisation:
Lets say our retailer expanded their storefront by building a new section with a cost of $2M. Where the normal operating expenses of a business would be recognised in the P&L statement, this capital expenditure is deemed to have a useful life of 20 years. As such, $100,000 per year is recognised under the ‘depreciation’ line, for the next 20 years.
Amortisation is much the same, but applies to intangible assets such as ‘goodwill’ from the acquisition of another company.
Why is this line important? Well, for our retailer they are recognising a $100,000 cost on their P&L every year, but they have already paid for the building works in a prior period. There is no actual cash outflows associated with this charge, so cashflow will be much stronger than profits suggest. This exact situation is what is happening with some of the big ASX miners such as Rio Tinto & BHP at present.
8 & 9. Interest received & Interest expense.
As explained in point 5, these lines get accounted for separately, so as not to distort a company’s true underlying profitability.
Why is this important? Well, our company currently pays $50k per annum in interest on a debt facility they drew down to finance their building works / store expansion. Lets say that debt will be repaid next year… all of a sudden an extra $50k falls to the bottom line and PBT increases 13.5% to $420k without any change in normal operations.
10. Profit Before Tax (PBT)
Pretty self explanatory this one… so why is it important? Well, recall in
5 reason P/E Ratios lie we looked at an example of Nanosonics – a company that had many years of tax losses to claim. In this case, receiving a tax refund as opposed to a tax bill made NPAT higher than PBT – distorting the company’s ‘normalised’ profit.
12. Net Profit After Tax (NPAT)
NPAT is the bottom line – and the ‘E’ in P/E ratio, but as we’ve seen its not always the best measure of a company’s true underlying earnings power, so its worthing paying attention to the other lines – not just rushing to the bottom.
One last point before i leave you to go explore some P&L’s.
Note, i’ve put a % next to a few lines in the P&L? (the % is the $ value of the line divided by the revenue). This is to highlight the key measures of a businesses profitability. Different industry sectors will have a ‘normal’ range of profit margins. For example, a SAAS business will typically have very high GP margins (60 – 80%), but an agricultural business may only have 20% G.P Margins, a retailer might have 50% G.P Margins, and an EBIT margin in the range of 5-10%. If you get to know the normal range of margins for an industry, you can quickly assess how profitable a company is compared to its peers. These margins are also a massive indicator of the ‘quality’ of a business.
Stay tuned for the dissection of the Balance Sheet & Cashflow statement in the coming weeks.