Almost all revenues and expenses of a company are found in its income statement. Thus, an analysis of revenues and expenses is more or less the same as an analysis of the income statement. Let’s consider these one by one.
Revenue is the total income a company is able to generate in a period. The principal source of a company’s income is naturally the income earned from the sale of its goods. For this reason, the term revenue is generally used interchangeably with sales turnover. However, companies also generate income from other sources. An analyst must explore these further to be able to comment upon the quality of a company’s earnings.
Revenue analyses are conducted with a two-fold objective – determining the quality of a company’s earnings and projecting future earnings.
The basic framework of the analysis is as follows:
This refers to the ability of a company’s income to reflect its true earnings potential. Investment decisions are based on expectations regarding future earnings of a company. For decisions to be sound, it is an absolute necessity that future earnings be stable and predictable. However, as we will find out in the next few paragraphs, there are some elements in the income statement that contaminate earnings. This makes it hard for analysts to project earnings.
The three main questions that you would like to ask in order to assess the quality of a company’s earnings are as follows:
A company has two main sources of revenue – sale of goods produced by it and other sources. The first of these sources – sale of goods and services – is the very reason a company is formed. It is, therefore, called a source of operating income. It is naturally expected to contribute the most to its earnings.
However, sometimes companies also earn money through other activities, such as income from various investments (not related to the core business) and profits from the sale of an asset (such as a piece of land or an unused factory building). These are called sources of non-operating income as they are not directly related to its business. They give the total revenue a boost in the period in which they occur, but are unlikely to recur in future periods.
For this reason, companies with a large proportion of earnings contributed by non-operating sources are said to exhibit low revenue quality. Such companies are not efficiently managed and are not utilizing their resources to the fullest. This makes investors skeptical about investing in them. For the purpose of fundamental analysis, you are better off excluding non-operating income from the analysis.
Sometimes, one encounters items such as 'revaluation gains' and 'decrease in deferred tax asset' on the income statement. These sources of revenue do not lead to any flow of cash to the company. They are merely complex accounting concepts that lead to speculative income for the company. While assessing the revenue of a company, they must be eliminated.
Although sales should be the primary source of revenue, a company that displays high sales growth from one period to another may not always make a good company. This is because companies sometimes sell goods for which they receive payment later. Such sales are called credit sales. They are reflected on the company’s income statement but don’t immediately lead to a generation of cash for it. Thus, a company with a large proportion of credit sales may be a dangerous company to invest in.
The extent of a company’s credit sales is sometimes defined by the industry it is in. In highly competitive industries, companies have to attract customers by offering them favorable terms of payment. In such industries, the proportion of credit sales is generally higher. You must compare the proportion of credit sales to total sales of a company with the same ratio of other companies in the industry.
Another assessment of sales quality can be done using the balance sheet. Credit sales of a company are recorded on the balance sheet as accounts receivable. As a general rule, a company whose accounts receivable are increasing from period to period has low quality earnings. Also, the length of time for which these amounts have remained outstanding is given in the annual report. Companies with a large amount of receivables outstanding for a long period display lower likelihood of recovering them. This is also a sign of low earnings quality.
Once all these adjustments have been made to revenue, what is obtained is called core or sustainable income. This is the value that must be used for comparison and projection.
Projecting future revenue is important because the value of a share will only increase in the future if the company’s earnings increase. By estimating future earnings, you can estimate the future growth potential of the company’s stock. You can also ascertain whether the price at which the stock is trading today is fair or not. Accordingly you can decide whether to buy it.
By the end of quality assessment, you will come to know what the company’s sustainable income is. This component of income is derived purely from its core operations and can, therefore, be expected to continue in the future. However, in the future, the company will also invest in new assets and may acquire other companies. This will increase its sales and generate more income.
Thus, earnings projects must also accommodate these. Further, every now and then, the company may also earn revenue from the non-core sources that we discarded earlier. These must also be factored into future projections. To accommodate these, you have to make some estimates and assumptions.
Some of the questions you might want to seek answers to in order to facilitate this are listed on the left.
These will be discussed further in the section on equity valuation. However, the answers to these questions cannot be found in the income statement. You have to go beyond the income statement and read other components of the annual report. Principal among these are the notes to the three financial statements and the section on management discussion and analysis (MD&A).
You must also explore financial papers, journals and reports published by industry bodies, such as Society of Indian Automobile Manufacturers (SIAM) for the auto industry; and stock brokerages.
Now, we move to the analysis of expenses.
Profits are the money left after you pay for all your expenses. This is why it is important to understand how a company spends its money. It helps identify if the company is managing its money efficiently. Secondly, if you know what the company spends money on, you can predict if the company’s expenses would rise or fall in the future. This, in turn, can affect its profitability.
Let us explore some of the questions regarding expense analysis that you might want to seek answers to.
A company incurs various expenses in order to produce goods and sell them in the market. Some of these are directly related to the process of production and sale, whereas others, although equally important, are supplementary to it. The ones that are directly related, such as cost of raw material and transportation costs, are called operating costs. Others, such as employee compensation and interest on debt raised for the business are called non-operating costs. While companies strive to reduce costs of both kinds, non-operating costs are generally harder to reduce. This is because they most of them are unavoidable. Therefore, companies with a high proportion of non-operating expenses are considered inefficient. In order to assess whether a company is truly spending money judiciously, you can calculate what percentage of sales a particular expense is and compare it with other companies in the same industry.
Another way of assessing whether a company is spending money wisely is to look at the specific heads of expenses mentioned in the income statement and notes to the income statement. You may then ask which of these expenses are essential, and which are not. Will a particular expense lead to greater income in the future? You may even assess which of the expenses are unusual and should therefore be removed to assess the true extent of a company’s expenditure.
Like revenues, expenses are also projected. The reason for this is that you are interested in knowing how much profit your company can make in the future. This can only be done once projected future expenses are subtracted from projected future incomes.
Again, certain questions must be asked to determine what the future trend of the company’s expenses could be. Questions related to the strategic intent and the future investment plans of the company feature prominently in the list of questions. As with revenues, here too you must explore beyond the three financial statements to find answers.
As with revenue, the company also incurs some expenses that are purely notional in nature and don’t entail an actual outflow of cash. Some of the most common ones are depreciation and amortization (i.e. the fall in the value of the company’s assets each year), and increase in deferred tax liability (the difference in tax calculated as per accounting standards and the tax calculated as per the government’s tax calculations).
These must be excluded to calculate the actual extent of a company’s expenses. For future analysis, they must only be included if they are expected to continue for a long period in future.company’s expenditure.
A company’s cost structure can also be divided into fixed and variable cost. Fixed cost is the category of costs that do not change with the level of production. For example, irrespective of the company’s level of output, the rent it pays for its production facility will remain the same. Thus, it is a fixed cost. On the other hand, some kinds of costs change with the level of output. For example, transportation and storage costs. They are called variable costs.
A cost structure comprising of a smaller component of fixed cost is considered efficient. This is because variable costs change with the level of output. Thus, whatever the level of output and sales, the profit margin of a company doesn’t change on account of variable cost. However, since fixed cost doesn’t change with level of output, it destroys a company’s profit margin in periods of low output. On the other hand, since it doesn’t increase with an increase in output either, it bolsters the company’s profits in periods of high output. This is known as leverage.
Fixed costs fall with improvements in technology and process designs. While a companies can always invest in technology, processes are generally optimized with time, as the management gains more experience and knowledge of the industry. This is called moving up the experience curve. In the next section, we will look at the analysis of assets and liabilities. Click here.
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