Decoding Income Statement - Part 1

Income statement is often misunderstood .........on a general level  intention is to record revenues generated and cost incurred in the process of generating those revenues.

Often the source of confusion is due to misunderstanding between Income and cash flow.  Cash flow statement's purpose is to record actual movement of cash where as income statement follows defined conventions known as accrued accounting.  Now the question is how to recognize 'revenue' when the cash received today and service is to be provided say over next year. Also if a machinery is sold can the cash raised be recognized as revenue?

Few examples on the income statement vs cash flow to help understand-

• Cost is recognized when the materials are consumed not when they are paid for. Thus if a business buys machinery, cash flows out ,its recognized as cash flow (not cost).Cost is recorded as depreciation over time. 
• Salary to be paid to the employees is recognized as cost even before its to be paid, thus no cash flow has taken place (until the end of month) but cost is recognized.  
• A loan repayment results in cash flow but from an income statement point of view is not a cost. The outstanding liability of loan is reduced by the amount of asset reduction. 
• Large one time gains/losses like selling a owned land is recognized a 'extraordinary income'. Such income is not to be mixed up with operating income. 

 More to come in later part so stay tuned ... 

Decoding Balance Sheet

Continuing our this financial statements quest, lets learn more about the Balance sheet(see earlier post here). We should first analyze what is being reported and measured.  Basically there are four primary parameters which are being measured

• Networth
• Total Assets
• Capital tied up in the business (capital employed)
• Working Capital

The below diagram gives an overview about the balance sheet

Assets	Liabilities
Fixed Assets(FA)	Owners Funds(OF)
	Long term Liabilities (LTL)
Short Term Assets (STA)
	Short Term Liabilities(STL)

.

Based on the above its now easy to derive the above terms being used ..

Owners Funds (Networth) is a measure of owners funds in the business which includes both the initial seed capital and reserves accumulated as a result of the business output

                                   OF =  FA + STA – (LTL +STL)

So basically it’s a difference between the assets and the liabilities of a business. Its also referred as book value. 

Total Assets is a measure of assets which help the business to succeed as a growing concern. It can be represented either from the asset side or liability side

            TA  = FA + STA     - Based on asset side

          TA = OF+LTL+STL     - Based on liabilities

Capital employed is a measure of long term capital in play in the business. Often the rate of return as a percentage of capital employed to compare investment candidates.It can be represented as

CE = FA+STA- STL   -Based on asset side

Or

CE = OF + LTL - Based on liabilities

Working Capital is a measure of day to day liquidity required for business to function. A real estate business may hold lot of assets however it may not be as liquid as a retail business.

Its represented as

 WC = STA – STL

Or

WC = OW+LTL – FA

These 4 values are key parameters which should be understood. We will be using these numbers to make sense of the business also these need to be converted into ratios to improve our analysis. 

Financial Statements Basics

The world is shouting stock ideas back and forth, you don’t know who’s right who’s wrong – Bulls eye buy stock ‘x’ its cheap sell stock ‘y’ it’s expensive. Everyone is an ‘expert’ and has an opinion to offer. What to believe?

I have been there myself, I didn’t understand who was right and who had lot of hope built into his numbers. Well in reality no one is going to come and tell you where the best or bad deals are.

A stock picker should be able to think for himself, if you have the knowledge and are willing to put an effort into understanding what’s behind these numbers you can make the decision yourself. Because the numbers will tell the story about the business, the numbers themselves mean nothing we should be able to infer the reasons behind them– the jump or drop in profits, change in margins etc.

As Graham said “while buying a stock you are buying part ownership in a business” you will do well if the business does well. The three basics reports we need to understand to be able to make a ownership judgement are

• Balance sheet
• Income statement
• Cash flow statement

All the above three reports are connected to each other, the income statements usually report on progress between two balance sheet periods. For example Q1 2011 income statement will be generating income from assets reported as part of 2010 balance sheet and profits generated will be reported as part of 2011 balance sheet.
There is no magic metric or ratio which can help us understand the business, we need to look at it from multiple angles to be in a position to appraise it correctly.

Balance sheet : The simplest way to understand the balance sheet is to look at two parts - Source of funds (Liabilities) and Use of funds (Assets). Basically where the money comes from and where its applied.

• Assets : Are Current assets (short term like Cash, Inventory, Accounts receivables and others) and Fixed Assets (longer term like Net fixed assets,Investment, Intangibles etc). Usually all these assets are represented on 'cost value' not 'market value' although this is debatable.

• Liabilities : Are Current liabilities (short term Account payable,Short term loans and others),Long term liabilities (Long term loans like mortgages, debentures etc)

• Owners Funds :Share capital and Reserves&Surplus. Its interesting that the money that the owners funded( 'paid up share capital') to start the company is also part of liabilities because the company has a life independent of the owners now .

Balance sheet can help an investor understand the nature of business of the company, some companies are ‘more liquid’ (means they have less fixed assets but higher cash example retail but others like heavy engineering usually have more of fixed assets ). So look at a balance sheet as a listing financial value of assets (of various forms) , these assets are used to generate the profits which makes the company running. Keep looking at the sheet over the years and you will notice the story of how assets are changing and shareholder equity growing as a result.

The basis of balance sheet is the double entry book keeping system. It was designed many years ago to make sure accountant does not make a mistake, so for every transaction the accountant makes two entries and they balance (Assets = Owners Funds + Liability)

Income Statement (Profit and Loss) :It lists what the business has earned vs. spent over a period of time . It shows the ‘Net Profit or Loss’ as the case may be, the key thing to remember is that income from one period cannot be mixed up with next and must stick to the accounting standards.

‘Revenue’ gives importance of item being ‘sold’ does not always means that cash (receipts) has been received for example: If a consulting company performs a work it can report it as revenue even though the cash will be received later.Similarly ‘Expenses’ also give preference to being recognized than paid so its identified that cash is due but may be paid at a later date.

Besides the some accounting twists like above income statement is like you family budget of income minus expenses.


Cash Flow Statement : Unlike the income statement Cash flow statement shows the actual movement of cash. Its usually categorized into Operating activities cashflow, Investing activities cashflow and Financing activities cashflow.

Cashflow statement can tell us if the business requires heavy expenditure to generate returns or not. Some businesses will constantly need buckets of cash to generate earnings and may not be a good one to earn for this reason.

Cashflow statement also tells us how much actual cash is coming in and we need to compare it with revenues from the income statement to understand better.

We will take an approach of looking at the most important metrics first so that it can understand the financial framework and then delve into details. Until next time happy investing !

Learning the language of business

Accounting is the language of business and its an imperfect language. Unless you are willing to put in the effort to learn accounting (read financial statements) you should not be selecting stocks yourself.-Warren Buffett.

I very often find lots of information on stock ideas floating around in the web and tv but hardly people talk about accounting and financial statements. This troubles me because if you cant understand them you should not be buying stocks. I have thus decided to elaborate and share information on this.

Lets try to make learning financial statements lots of fun... stay tuned !!!

How exactly is an IPO price decided?

I received a query from my friend and reader Ranjit. He has seen lots of IPO coming into the market and is unsure which ones are good and wants to understand this process of fixing the price so as to be able to make an informed decision.

Methodology
The process of deciding IPO price is generally done by what is known as ‘Book building process’.

Firstly the number of shares to be issued is decided and merchant bankers with book running lead manager appointed.These guys manage the whole show until the company is listed. The lower price end is known as the floor price and investors are expected to at least meet that price in order to make a valid application. Floor price is decided based on various factors like comparison with industry peers, past financial statements, track record of promoters and market sentiment etc. It is in the interest of the company to keep this price rational because if it’s too high investors may not bid for the issue and book building process will fail. This happened to companies like Wockhardt Hospitals,Emmar MGF etc.. The higher end of the range is maximum about 1.2 times the floor price this gives us the price range.

Investors now bid for number as well as price and the highest price(within the range) at which the complete book can be sold is decided as final issue price. For example
Assume that the range is Rs 100 – 120, and only 80% of book can be done at 120 then the price is lowered to the price at which 100% of the shares can be sold. Investors who bid at a higher price are sold at a decided price and refunded the difference and investors who bid lower than the decided price are not allotted any shares and refunded completely.

Reliance Power was an example of a well marketed IPO, the company sold shares without any earnings from operations at the price of about 5 digit P/E and this left a bad taste in the mouth of investors when shares dropped below issue price. The company was forced to give a rights issue to pacify investors since the promoter does not want his reputation to be hurt. Once investor sentiment is hurt it’s very difficult for the company to raise money from the market again.IPO listed when market sentiment was at its peak and people were willing to pay really high prices for stocks but ultimately the market will fall in line with value regardless of marketing gimmicks.

Coal India IPO was an example of well priced IPO this generated lot of interest and made money for the investors. Market respects good companies offered at fair prices. As a investor we must always try to read the ‘red-herring’ prospectus. This contains info about rational for deciding the price and describes the business of the company etc. We should carefully do an evaluation based on quantitative and qualitative factors.

So why do IPO’s fail sometimes?

Promoter’s short term greed is usually the key factor. If a new company comes into the market its price has to be rationally comparable to other listed companies in the same space. If an issue list during situation when market sentiment is driving risk aversion among investors even good issues may not get the attention they deserve.

However once a company lists and begins to perform more people will line up to buy at higher prices thus pushing the price up and making the promoter rich in the process (assuming he is the majority share holder) however we live in a world dominated with fast –foods but junk food does come back to bite you and so will the mis priced IPO.