I have decided that I will blog about different aspects of FA and this will probably spread over a few posts to make it more manageable. My formal education in Economics and Business Administration, specifically, Financial Management help to inform my FA. Of course, these are textbook material and I try to keep myself up to date by reading weekly periodicals such as Newsweek and The EDGE. I also read analysts' reports, not to blindly follow buy or sell calls but more as an idea generating exercise. Being in business development also gives me an inside feel of the business climate especially in South East Asia where the company I work for has the greatest exposure.
In an earlier post, I said that FA could be done on many levels but the most basic level would be looking at a company's financial numbers. I have learnt much to my own regret that to overlook this for any reason (usually due to complacency) could be a big mistake.
What is an Income Statement? This basically tells us how a company's operations performed over a period of time. Right at the top is the gross revenue (GR) the company has generated. In a company that deals with goods, you will have to deduct the cost of goods to arrive at the gross profit or GP. For people who are in tune with Warren Buffet's investment philosophy, you would remember that he says we should always look for companies with GPs of no less than 20%. In fact, he consistently targets companies with GPs of 40% or higher.
So, let us say that a company has a gross revenue of S$100,000 and their cost of goods is S$60,000. Gross profit is S$40,000. As a percentage, the GP is S$40,000(GP)/S$100,000(GR) = 40%. Simple enough.
Does this mean that everytime we see businesses which generate a GP of 40% or more, it is a good buy? No, we continue by looking at the next part of the Income Statement which shows the operating expenses. These are the Selling, General and Administration expenses or what is referred to as SGA, the Research and Development (R&D) expenses and Depreciation. Upon taking out all these expenses, we arrive at the Operating Profit or Loss of the company. As you can probably tell, a company which incurs massive expenses despite a high GP is not going to have much left for the shareholders.
The next part is the Interest Expense, Gains or Losses from sale of assets and Others. Taking all these out give us the Income of the company before tax.
We want to make sure that the company is not borrowing too much and not paying too much for its borrowings. This is what is known as leverage. There are many companies which are heavily leveraged and as long as they are making more money than the interest they are serving on their loans, they look good but if the tide turns and, in the last financial crisis, we saw how quickly they could turn, things could become very ugly. So, imagine if revenue dries up during a recession and the interest expense remains high, not a pretty picture.
Having said this, leveraging is not all bad. Credit is said to be the lifeblood of businesses. Few businesses in this world operate with zero leveraging. As long as it is kept at a level that is manageable, a level that will not threaten the viability of the company in the worst case scenario, it is acceptable. This is what is called stress testing.
The next part of the Income Statement would be the taxes paid. Once this is taken out, we have the net earnings of the company.
I hope you have found this post to be informative and I will blog about the Balance Sheet and Cash Flow Statement in upcoming posts.
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