Understanding financial statements (Part 1) - The income statement

To be an investor, you have to know how to read financial statements. I would say that this is a skill that every investor must know. In fact, Warren Buffet said that the greatest skill a young person can learn during his or her school days is the skill of accounting.

In an annual report, you will basically find 3 financial statements.

1) The Income Statement
2) The Balance Sheet
3) The Cash Flow Statement

I will go through all 3 statements in detail as simple as I can. For this post, we shall use the company Singtel's financial statement as an example. It is the largest company listed on SGX in terms of market capitalization. It is also one of the blue chip stocks and is one of the 30 components stock that make up the Straits Times Index (STI).

Let's start with the income statement.

The Income Statement

I personally use investing.businessweek.com to read up on a company's financial report. You can access Singtel's income statement here. Alternatively, you can get the full annual report from either SGX or Singtel's own investor's relation website.

Revenue
The income statement shows how much a company is making or losing. The first thing we see on the income statement is revenue. It is the sales the company has made for that quarter or year. This is the money it earned through selling a service or product. For Singtel, it can be the selling of mobile phone service which we pay a monthly subscription. The money collected is recorded as revenue. For Singtel, its 2012 revenue was $18.18 Billion

Cost of goods sold
Next, we see the cost of goods sold. This is the cost that is directly involved in creating the revenue. It can be labor costs, raw material costs, or the initial cost price of the goods. This is deducted from the revenue.

Gross Profit
After deducting cost of goods sold from revenue, we get gross profit. Gross profit is revenue minus cost of goods sold. For Singtel, its 2012 gross profit was $5.5 Billion. This is after deducting cost of goods sold of 12.7 Billion.

Selling General & Admin Expenses, Total
Next we see Selling General & Admin Expenses. This is also known as operating expenses and includes expenses such as marketing costs, administrative salaries and research and development costs.

Depreciation & Amortization, Total
The next is Depreciation & Amortization. This cost is the depreciation on assets that the company purchases. Assets like machineries and motor vehicles will drop in value over time. The depreciation reflects the cost of the depreciation.

Operating Income
Another important one we should know is operating income. This is revenue minus cost of goods sold and also all operating expenses. It is the profit the company made from its actual operations. For Singtel, it is the earnings from its main business in the mobile, internet and IPTV services.

Interest Expense/Income
You'll see the next 2 rows being interest expense then interest income. This records the interest the company paid on bonds it issued or the interest collected from bonds it owns.

EBT, Including Unusual Items
EBT means earnings before taxes. A more accurate term you can look at is EBITA. This is earnings before interest, taxes and amortization. You will realise that before the EBT, there is a big chunk of expenses called other non-operating expenses. Accountants may remove this expense and not include it in the calculation towards earnings.

Net Income
This is the company's profit after all expenses have been deducted. It is the income that most companies will report on when they release thier earnings result. However, do note that the figure may be distorted as it includes one time charges or investment income. It does not really reflect on the true operating profit of the company. Investors sometimes look at operating income as it reflects the income earned from its actual operations in the business.

Summary
We have just gone through the various items included in the income statement. In summary, the income statement reflects the income and expenses of the company. For an investor, we do not just analyze a company's earnings power using the income statement only. You'll come to realise that the cash flow statement is a more accurate measure of a company's financial health. Income can be distorted more easily while cash flow is harder to fake. It is the actual cash that flows into the company business.

The next 2 financial statements, namely the balance sheet and the cash flow statement, will be discussed in the next part.

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Related Posts:

1. How to pick stocks (Part 1) - Economic Moats

2. How to pick stocks (Part 2) - The profitability of a business

How to pick stocks (Part 2) - The profitability of a business

In my previous blog post, we discussed on economic moats and why it is important for us to identify which industry the company belongs to. If you have not read that post, you can read it here: How to pick stocks (Part 1) – Economic Moats

To know if a company is doing well in that industry, we can look at various metrics and financial ratios to give us a clearer view. This will give us a confirmation that it has a strong economic moat.

How to know if a company is generating profits?

Financial statements are important in our analysis of a company. It reports on the current health of the company such as how much revenue it is generating, how much money it is spending, how much debt it has, how much cash it has etc.

There are basically 3 types of financial statements we see in a company’s financial report namely:
1) The income statement
2) The Balance Sheet
3) The Cash flow Statement

We’ll discuss in depth the above 3 statements in a separate blog post. For now, we’ll just touch on a few simple financial terms to start with.


Free Cash Flow
To evaluate a company’s profitability, first we look at free cash flow. This is calculated by using cash flow from operations minus capital expenditures.

Free Cash Flow (FCF) = CF from operations – Capital expenditure (Capex)

The amount of cash flow from operations and capital expenditure can be found in the cash flow statement in a company’s financial report. Firms that are able to generate free cash flow essentially have money left over after reinvesting whatever they need to keep the business running. This includes spending on upgrading factories, building up properties, buying or replacing worn out equipments. Thus, free cash flow is whatever extra cash that the company can generate without damaging the core business.

Net Margins
Net margins is simply net income as a percentage of sales (revenue).

Net Margins=[(Net Income)/Revenue] x 100%

This shows us how much profit the firm can keep after deducting all the necessary expenditures. The net income and sales figures can be found in a company’s income statement. For example, if a firm has $50k in sales or revenue and net profit of $10k, we can say that this firm has a net margin of 20%. Firms that can generate more than 15% net margins are generally alright.

Return on Equity
Return on Equity (ROE) is net income as a percentage of shareholder’s equity. It measures how much profit per dollar the company is generating from the capital that shareholder’s have invested in. Firms that post a ROE of above 15% consistently are generating returns on shareholder’s money which means they are likely to have an economic moat.

Return on Assets
Return on Assets (ROA) is net income as a percentage of a firm’s assets. It measures how efficient the firm is in generating profits from its assets. If a firm can generate a ROA of 6-7% consistently, it may have some competitive advantage over its peers. ROE and ROA have already been calculated in percentages on most financial websites such as Bloomberg. You can use this website to view financial statements of companies and also the various financial ratios like ROE and ROA: http://investing.businessweek.com/research/company/overview/overview.asp

Conclusion 
What we've just discussed are just some simple ways we can evaluate a company’s profitability. It is important to look at the metrics comparing for a few years. If a company can consistently have good FCF, decent net margins, high ROE and ROA, then it has a stronger economic moat and can keep competitors away for an extended period of time. These are only just a guide for us when picking stocks.

There are many other ways to analyse a company and I will discuss it in subsequent blog posts. It is also important to compare companies against other companies in the same industry to see if it is truly ahead of competition.

In the next series, I will write on how to interpret the various financial statements. We'll also look at how to know if a company is worth buying at that current price by valuing the true value of the company against its stock price. Stay tune for more!

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Recession Heroes Ep 1 - Why people lose their money during crisis?

Just watched the first episode of recession heros on channel 5. This first true story is quite inspiration and I would like to summarise the story here.

The guy in the story lost all his money during the september 11 stock market crash.

Here's a summary of his story:

Father was a businessman in Malaysia.  Business was doing well until his father got cheated by a business partner and lost everything. His family was in debt for a few million dollars. They later moved to Singapore. To supplement his family income, he came out to work at a young age of 14. Work as a cleaner in the morning, gas station pump attendant in the afternoon from 1pm-10pm then wash taxi at night all the way to 1am. He worked this for 1 and a half years.

After that, he went to serve National Service in the singapore police force. Read many books on computers and developed an interest in it. Went on to secure a job as a computer trainer and quickly climbed up the corporate ladder to earn $12000 at the age of 25.

He got really arrogant and his ego became very big. He said his ego was more than 10 times his head. He would scold and despise his staff and colleagues. Started investing in stocks and turn a $50k portfolio to $500k. He became even more proud and think that he was a genius.

During the september 11 terrorist attack on the twin towers, the stock market tumbled and he realised his stocks portfolio was only left with $7000. He had invested all his money into stocks.

After that incident, he wanted to build up a business and started a company with another guy. The partnership turned sour and he was caught up in a 3 year long law suit. He lost everything at that point.

After all these failures, he finally understood what it means to be humble. 

He went on to pursue his dream again to own a business and start up a company with his wife called commsgate which provides IT infrastructure for SMEs. His business flourished until now.

2 things he learnt from the crisis:

1) Do not dabble in stocks with money you cannot afford to lose. Must know the rule of the game.

2) Wealth is a habit. Must build the habit to save and invest regularly for a leriod of time.

I do feel that the stock market is a place that will reward the humble and punish the rich. If a person is proud and looks down on others, it is easy for him to lose everything and be destroyed by his own ego. Invest with a humble attitude and learn the rule of the game to succeed. Risk management is important in investing.

Hope you're inspired by this story. 

This is a true story as shown on mediacorp channel 5. Watch the next episode every monday at 9pm.

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How to pick stocks (Part 1) - Economic Moats

Finally, i'm more free to continue blogging and write up good articles for readers of my blog. Just finished my exams yesterday and looking forward to my Taiwan holiday trip in one weeks time. In the meantime, i'll be starting a series of posts on how to pick stocks. As an economics student, i'll start of with what is familiar to me which is how to analyse a company's economic moat. Many of you may have already heard this term. Read on to find out more.

Introduction
How to know what companies to invest in? This is a question many people will ask. When choosing which companies to buy, we need to know its competitive advantage against other companies. Investopedia defines economic moats as: "The competitive advantage that one company has over other companies in the same industry. This term was coined by renowned investor Warren Buffett."

An economic moat is like a company building a fortress. By having a competitive advantage, firms can continue to have profits in the long run. As a shareholder of a company, you'll also want the company to continue generating profits and cash flow. In this way, the share price can continue rising and dividends will also increase with it.

Category of Industry Competition
In economics class, we learn that there are basically 4 different industry competition:

1) Monopoly Competition
2) Oligopoly Competition
3) Monopolistic Competition
4) Perfect Competition

Monopoly
From the name, you can roughly know what sort of industry it is. In a monopoly, there is only one firm in that industry and this firm has complete control of the market. It is similar to a familiar board game that we play called monopoly. The objective of the game is to buy up all the properties and gain control of the market. This industry has high barriers to entry through legal restrictions, economies of scale and control of essential resources. In simple terms, it means that if other firms or competitors want to enter this industry, it is almost impossible. Examples of firms in this industries are utilities companies which provides water and electricity. Very seldom do we see listed companies which belongs in a Monopoly.

Oligopoly
An oligopoly consists of around 3-7 firms that dominate the market. Each firm has a big market share with few competitors. However, the competition among these few firms are intensive and firms need to constantly have a strategy to stay ahead of competition. There is often a leader in the market among the few firms and others act as followers. Examples of firms in this industries are Telcos. In Singapore context, they are namely Singtel, Starhub and M1. From these 3 names, we can roughly guess who is the leader in the market with the biggest market share.

Monopolistic Competition
There are large number of firms in this industry (30 or more). They offer similar but slightly different products. With so many firms in the market, each firm only has a small market share. Firms differentiate their products through product differentiation by advertising and building their brand name. Examples of firms in this industry are food and beverage companies. In Singapore, we see many different F&B companies. Most of them own several restaurants and fast food chains. An example is Breadtalk which owns a bakery, food court, restaurants etc. It has established its brand over the years and this is a form of economic moat.

Perfect Competition
In a perfect competition, there are large number of buyers and sellers. There is a standardised product. In simple terms, these are markets like foreign exchange market, commodity market etc.

Understanding which category the firm belongs to is important in determining the firms future profitability and how long it can hold off competition.

Building an Economic Moat
We always need to ask ourselves why is the firm suitable for investing? Are profits still coming in and if so is there a threat that competitors can steal away its customers?

There are ways that firms can build sustainable competitive advantage.

1) Differentiate their products from competitors 
For firms in the monopolistic competition, this is especially important.

2) Building a brand
A brand is a form of product differentiation. People tend to look for brands that they trust to determine the quality of their products. A strong brand attracts customers and prevents competitors from taking aways their customer.

3) Offering similar products or services at a lower cost  
If a firm is able to offer similar products at a lower costs, this creates a competitive advantage for it. Firms that are able to do that creates high barriers of entry and makes it difficult for new firms to enter. Airline companies have been driving down costs by offering budget services. Singapore airlines for example, has a fairly new budget airline Scoot. Their planes are old SQ air buses which are much bigger than other budget airlines. In this way, they can have more passengers on board at a time and the price each passenger pays can be cheaper.

4) Creating high switching costs
Firms which provide services and products such as IT systems can create high switching costs. Especially for banking systems, they are so complicated that banks will not want to risk in changing to other systems. In this case, most likely the firm that provides the service will continue providing it for a long time. An example of a listed company in Singapore is Silverlake Axis. They provided integrated banking solutions to various banks around the world.

5) Locking out competitors
Firms can lock out competitors by having regulatory exclusivity and patents for their products. Casinos require licenses and in a country, very few licenses are given out. A firm that has this license gain a competitive advantage. Las Vagas Sands, a well known casino brand has been having this competitive advantage for a long time and are still doing well until now.

Patents can lead to years of extremely high profits for a firm. Breakthrough medical products have patents to protect them. Pharmaceutical companies with patented products will have almost guaranteed profits for many years.

Conclusion
Firms in certain industry will find it easier to make money compared to other industries. In industries where there are many firms, competition will lower market share and in turn lower profits for that firm. This is not good news for shareholders. We need to identify which industry the firm belongs to in order to critically access the firm's profits in the long run.

In the next series, i'll discuss on how to evaluate the profitability of a company using various financial ratios.

Part 2 is now available. Click here to read: How to pick stocks (Part 2) - The profitability of a business

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