Back to Basics: Income Statement Items

This is the fifth piece in our Back to Basic Series, in which we will try to explain the income statement items from a value investing perspective. The previous four pieces are:

1. Back to Basics – Investment Return Ratios
2. Back to Basics - Earnings Yield and Forward Rate of Return
3. Back to Basics: Valuation Ratios That Are Important to Value Investors
4. Methods for Arriving at the Fair Value of Companies

Revenue

Also referred to 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.

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

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 stalwarts, those growing between 10 to 20% a year.

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

Revenue can be manipulated by changing 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 accounts payable or accounts receivables.

Cost of Goods Sold (COGS)

Cost of goods sold (COGS) refers to the inventory costs of those goods a business has sold during a particular period.

Guru explains:

Cost of Goods Sold is directly linked to profitability of the company through Gross Margin:

Gross margin = (Revenue - Cost of goods sold) / Revenue

A company that has a “moat” can usually maintain or even expand their Gross Margin. A company can increase its Gross Margin in two ways. It can increase the prices of the goods it sells and keeps its Cost of Goods Sold unchanged. Or it can keep the sales price unchanged and squeeze its suppliers to reduce the Cost of Goods Sold. Warren Buffett believes businesses with the power to raise prices have “moats.”

Cost of Goods Sold is also directly linked to another concept called Inventory Turnover:

Inventory Turnover = Cost of goods sold / Average Inventory

Inventory Turnover measures how fast the company turns over its inventory within a year. A higher inventory turnover means the company has light inventory. Therefore the company spends less money on storage, write downs and obsolete inventory. If the inventory is too light, it may affect sales because the company may not have enough to meet demand.

Usually retailers pile up their inventories at holiday seasons to meet the stronger demand. Therefore, the inventory of a particular quarter of a year should not be used to calculate inventory turnover. An average inventory is a better indication.

Gross Profit

Gross Profit is the different between the sale prices and the cost of buying or producing the goods. It is calculated as:

Gross Profit = Revenue – Cost of Goods Sold.

Gross Profit is the numerator in the calculation of Gross Margin:

Gross margin

= Gross Profit / Revenue

= (Revenue - Cost of goods sold) / Revenue

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.

SGA - Selling, General, & Admin. Expense.

Selling, General & Admin. Expense (SGA) includes the direct and indirect costs and all general and administrative expenses of a company. For instance, personnel cost, advertising, rent and communication costs are all part of SGA.

An efficient operation keeps SGA costs low and thus has higher profit margins. The percentage of SGA relative to total revenue is an indication of how efficiently the company operates. Comparing this percentage among the companies in the same industry is a good way of finding more efficient operations. A comparison of the SGA cost relative to the revenue with the historical value can also be an indication of how efficient the company has become.

Chart: historical SGA relative to revenue, compared among competitors.

Research & Development (R&D)

This is the expense the company spent on research and development.

Earnings Before Depreciationand Amortization (EBITDA)

Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA) is what the company earns before it expenses interest, taxes, depreciation and amortization. EBITDA is calculated as

EBITDA

= Revenue – Cost of Goods Sold - Selling, General, & Admin. Expense (SGA) - Research & Development (R&D)

= Gross Profit - Selling, General, & Admin. Expense (SGA) - Research & Development (R&D)

Guru explains:

EBITDAis a cash flow measure that ignores changes in working capital. EBITDA minus Depreciation and Amortization (DA) equals Operating Income. Operating Income is profit before interest and taxes. Of course, Interest and taxes need to be paid.

While depreciation and amortization expenses do not need to be paid in cash, assets – especially tangible assets – do need to be replaced over time. EBITDA is not a measure of profit in any sense. EBITDA is a measure of cash generation by a business where the uses of that cash may be more or less discretionary depending on the nature of the business.

The EBITDA of a TV station is largely discretionary. Owners may use much of the EBITDA generated by a TV station as they see fit. The EBITDA of a railroad is largely non-discretionary. Owners must use much of the EBITDA generated by a railroad to replace the physical assets of the railroad, or the business will literally fall apart over time.

EBITDA can be thought of as the cash a business generates that is available to:

· Add more inventory

· Add more receivables

· Replace property, plant, and equipment

· Add more property, plant, and equipment

· Pay interest

· Pay taxes

· And finally: pay owners

EBITDA is widely used in financial analysis because Depreciation and Amortization are not present day cash expenses. Depreciation and amortization are the spreading out of the costs of assets over the time in which those assets provide benefits. Today’s depreciation and amortization expenses relate to assets bought in the past. The assets being expensed may or may not need to be replaced in the future. And the cost to replace the assets may be more or less than it was in the past. For this reason, the depreciation and amortization expenses a company records in the present year may have no relationship to the actual cash costs needed to maintain its assets in future years.

A company’s depreciation expense depends on both its expectations about the assets it owns and its choice of accounting methods. Two companies owning identical assets may have different depreciation expenses because they have different expectations about the useful lives of those assets and because they make different accounting choices.

Analysts use EBITDA to remove this element of personal choice from a company’s accounting statements. The use of EBITDA is an attempt to make the results of different companies more comparable and uniform.

Although depreciation is not a cash cost it is a real business cost because the company has to pay for the fixed assets when they purchase them. Both Warren Buffett and Charlie Munger hate the idea of EDITDA because in this calculation, depreciation is not counted as an expense.

EBITDA over Revenue is a good metric for comparing the operating efficiencies between companies because EBITDA is less vulnerable to companies’ accounting choices. For this reason, EBITDA is used in ranking the Predictability of Companies. Also price/EBITDA is sometimes used in valuations.

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

One of the key tenets of Generally Accepted Accounting Principles (GAAP) is “the matching principle.” The matching principle states that companies should report associated costs and benefits at the same time.

For example:

· If a company buys a $300 million cruise ship in 1982 and then sells tickets to passengers for the next 30 years, the company should not report a $300 million expense in 1982 and then ticket sales for 1982 through 2012. Instead, the company should spread the purchase price of the ship (the cost) over the same time period it sells tickets (the benefit).

To create income statements that meet the matching principle, accountants use an expense called depreciation.

So, instead of reporting a $300 million “purchase” expense in 1982, the company might:

· Report a $30 million “depreciation” expense in 1982, 1983, 1984... and every year after that for the 30 years the company expects to sell tickets to passengers on this cruise ship.

To calculate depreciation, a company must make estimates and choices such as:

· The cost of the asset

· The useful life of the asset

· The salvage value of the asset at the end of its useful life

· And a way of spreading the cost of the asset to match the time when the asset provides benefits

The range of different ways of “spreading the cost” under GAAP accounting is too long to list. However, public companies in the U.S. explain their depreciation choices to shareholders in a note to their financial statements. It is critical that investors read this note. Investors can find this note in the company’s 10-K.

Past depreciation expenses accumulate on the balance sheet. Most public companies choose not to show this “contra asset” account on the balance sheet they present to shareholders. Instead, they simply show a single item. This single asset item may be marked “Net,” such as “Property, Plant and Equipment – Net.” It is actually the asset account netted against the contra asset account.

A contra asset account is an account that offsets an asset account. So, for example a company might have:

· Property, Plant and Equipment – Gross: $150 million

· Accumulated Depreciation: $120 million

· Property, Plant and Equipment – Net: $30 million

In this case, the only item likely to be shown on the balance sheet is “Property, Plant and Equipment – Net.” This is the cost of the company’s property, plant and equipment (asset account) minus the accumulated depreciation (the contra asset account). It means the company’s assets cost $150 million, the company has reported $120 million in depreciation expense over the years and the company is now reporting the assets have a book value of $30 million.

It is possible for a company to have “fully depreciated assets” on its balance sheet. This means the company’s estimate of the useful life of the asset was shorter than the asset’s actual useful life. As a result, the asset – although it is still being used – is carried on the balance sheet at its salvage value.

This is a reminder that depreciation involves estimates and choices. It is not an infallible process.

Companies do not have cash layout for depreciation. Therefore, depreciation is added back in the cash flow statement.

Although depreciation is not a cash cost, it is a real business cost because the company has to pay for the fixed assets when it purchases them. Both Warren Buffett and Charlie Munger hate the idea of EDITDA because depreciation is not included as an expense. Warren Buffett even jokingly said, “We prefer earnings before everything” when criticizing the abuse of EDITDA.

Depreciation estimates make the calculation of net income susceptible to management’s accounting choices. These choices can be either overly aggressive or overly conservative.

Operating Income or EBIT

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.

Operating Income (EBIT)

= Revenue – Cost of Goods Sold - Selling, General, & Admin. Expense (SGA) - Research & Development (R&D) – Depreciation, Depletion & Amortization (DDA)

= Gross Profit - Selling, General, & Admin. Expense (SGA) - Research & Development (R&D)

– Depreciation, Depletion & Amortization (DDA)

= EBITDA – Depreciation, Depletion & Amortization (DDA)

Guru explains

Operating Income or EBIT is linked to Return on Capital for both regular definition and Joel Greenblatt’s definition.

Return on Capital (ROC) = (EBIT – Adjusted Taxes) / (Book Value of Debt + Book Value of Equity – Cash)

Joel Greenblatt’s definition of Return on Capital:

Return on Capital = EBIT / (Net fixed Assets + Working Capital)

It is also linked to Joel Greenblatt’s definition of Earnings Yield:

Earnings Yield = Earnings before Interest & Taxes / Enterprise Value.

EBIT is also linked to Operating Margin:

Operating Margin = Operating Income (EBIT) / Total Revenue.

Compared with a company’s 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 company’s 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 (NYSE:NOK)’s problems were well known and its stock had lost more than 90% of its market value since 2007. But Nokia’s 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. GuruFocus’s Buffett-Munger screener requires that the profit margin be either consistent or expanding. The Model Portfolio of the Buffett-Munger screener has outperformed the market every year since inception in 2009.

Interest Income/Expense

Interest Expense is the amount of interest a company paid during the same reporting period on the debt it carries on its balance sheet. This will be deducted from its operating income.

The company may also earn interest on the cash it carries on its balance sheet. This will be added to its income.

Ben Graham required that a company must have — at minimum — produced average earnings at least five times the interest expenses. This means that the company’s operating earnings needs to be at least five times higher than interest expenses.

Non-Recurring Items (NRI)

Non-Recurring Items are the incomes received or expenses incurred by the business that are not from regular operations. Examples of NRI include gains (losses) from plant shutdown, lease-breaking fees, lawsuit, write-offs, write-downs, restructuring costs or sales of an investment, discontinued operations, etc.

NRI can impact a company’s reported income drastically.

GuruFocus lists a P/E (NRI), which is the price/earnings before NRI. We believe it more accurately reflects the valuation of the company.

Pre-Tax Income

This is the income a company pays tax on. It is after all the costs and NRI items.

Net Income

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 (SGA) - Research & Development (R&D) – Depreciation, Depletion & Amortization (DDA) – Interest Expense – Non-Recurring Items (NRI) – Tax Expense

= EBITDA – Depreciation, Depletion & Amortization (DDA) – Interest Expense – Non-Recurring Items (NRI) – Tax Expense

= Operating Income – Interest Expense – Non-Recurring Items (NRI) – Tax Expense

= Pre-Tax Income – Tax Expense

Guru explains

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

Earnings-per-Share (EPS) = (Net Income – Preferred Dividends) / Total Shares Outstanding

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.

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