So, this is one of the most important aspects that we need to analyse before investing because accounting is the language of business. If you don’t understand accounts, then you’ll be easily fooled into buying a crap business and end up losing a lot of money. Don’t worry you don’t need formal training as an accountant to understand a company’s financial statements. You need to know just enough which will help you make sense of the different entries and their logic. Then, when you notice a pattern over some years of financial data, you’ll be able to derive meaningful insights. It’s not as difficult as it sounds. Trust me. Listed companies share their quarterly and annual Profit & Loss statement, Balance Sheet, and Cash Flow statement.
Before we start, it’s important for you to know the 3 golden rules of accountancy:
Debit what comes in and Credit what goes out
Debit the receiver and Credit the giver
Debit the expenses and Credit the income
You need to keep the above in mind because they represent the logic behind why some entries will get added while others are subtracted.
Now let’s talk about the Profit and Loss statement. The image represents a typical P/L statement also known as the Income statement. I’ve broken it down to its constituent parts so let’s go a little deeper into them.
First up, is Sales or Revenue. This is what drives sustainable business growth. Even though profit growth is one of the major drivers of growth in share prices, profit growth does not happen in isolation. Sales growth is most often a necessary condition to profit growth. Hence a solid YoY growth % in sales is one of the good indicators of a health business because we know there is a growing demand for the company’s product or service AND the company can address that demand. Investors must also be alert to sales contribution from non-core operations. This is shown as ‘Other Income’ under ‘Sales’.
From the Sales figure, we deduct Cost of Goods Sold to arrive at what we call ‘Gross Profit’. Cost of Goods Sold includes all types of expenses that are directly tied to running the business. These can be cost of raw materials, running machinery and equipment and labor costs. When we divide ‘Gross Profit’ by Sales, the % figure we get is called the Gross Profit margin.
Moving forward, from the Gross Profit, we deduct operating expenses like selling & administrative expenses, depreciation and amortization, advertising, R&D to produce Operating Profit. When we divide Operating Profit by Sales, the % figure we get is called the Operating Profit Margin.
From the Operating Profit, we deduct interest expenses and add other income to get Profit before Tax. After deducting the % tax, we get Net Profit or Profit After Tax.
It’s that simple. However, fraud companies often try to manipulate these entries to show artificially suppressed or magnified profits. We’ll explore this more in detail in the blog Accounting Red Flags.
When you progress in your investing journey, you’ll notice a lot of investors focusing on EBITDA & EPS. EBITDA refers to Earnings Before Interest Taxes Depreciation and Amortization. The way to calculate this figure is to take Operating Profit and add Depreciation & Amortization to it. A lot of investors emphasize on high EBITDA to OCF conversion.
EPS is Earnings per share and managements like to boast of generating high EPS. However, this figure is prone to manipulation as the ‘earnings’ bit does not necessarily reflect the company receiving cash. Sometimes profits can stay stagnant but if the company does a buyback of its shares, then the EPS will jump. Therefore, I don’t recommend paying too much attention to this figure.
That’s it. That’s how easy it is to read a Profit & Loss Statement. I would recommend you practice reading as many P&L statements as you can. This will help you understand them better and over time help you become a better investor. To understand how to analyse Balance Sheets and Cash Flow Statements read my blogs on them. If you want to read more about analysing financial statements, you can go through my blog Analysing A Few Financial Statements.
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