Interpretation of Financial Statements

Durable Competitive Advantage (DCA)

Aim is to find a company with a durable competitive advantage (DCA)

Sells a unique product or service or to be low cost buyer and seller of a product or service.
Eg. Coca-Cola, Walmart, Railways etc

Consistency in,

- Gross margins

- Little/ no debt

- No large sums in R&D

From Income Statement

i. Company's margins

ii. Return equity

iii. Consistency & direction of earnings

From Balance Sheet

i. Amount of cash

ii. Amount of long term debt

iii. Net worth

From Cash Flow Statement

i. Money on capital improvements

Balance Sheet
The Balance Sheet is also called statement of financial position. It contains the 3 broad
headings of Assets, Liabilities and the combined Networth

Networth = Shareholder's equity = Assets - Liabilities

Assets

Cash and Cash Equivalent can be created by

- Selling of new bonds & equity to public

- Selling an existing business/asset

- Cash generated from ongoing business. Check the balance sheet of last 7 years.

Inventory

- Look for an inventory and net earnings that are on a corresponding rise

- Lookout if there is a ramp up and then a rapid ramp down of inventories

Receivables

- If a company is consistently showing lower % of net receivables to gross sales than

competitors then it has a DCA.

- Receivables - Bad Debt = Net Receivables.

Plant/Property/Equipment

- Carried in the balance sheet at original cost less accumulated depreciation

- Not having them can be a good thing

- A company should not need to constantly upgrade its equipment to keep up with
competition.

Intangible Assets

- Only a value ascertained by a third party can be carried on the balance sheet at their fair
value. eg: patents

- Brand names such as coca-cola / Wrigley's though are worth billions are not carried on
their balance sheet

- This advantage remains hidden from investors for so long.

Long Term Investments

- carried on books a their cost/mkt price. whichever is lower

- cannot be marked above cost even if the investments have appreciated in value

Assets and Return on total assets: Critical in banking

N etEarnings
ReturnOnAssets =
T otalAssets

May not be very accurate at determining which company has a DCA

Current Liabilities

Debts/Obligations due within the fiscal year

Accounts Payable/Accrued Expences/Current Liabilities

Standalone they tell little

Short Term Debt

- Due within the year

- Smartest/Safest way to make money in banking is to borrow long term and lend it long
term.

- Easy but risky, borrow short term and lend it long term. (Check ratio of short term to long
term debt, short term shou be lower)

Long Term Debt

- Companies with DCA do not have the need for large long term debts

- Such companies should ideally be able to pay off their long terin debts if need be with the
earnings of 3-4 years

Deferred tax and other liabilities

Not very helpful to determine DCA

Debt to Equity ratio

T otalLiabilities
DebtT oEquityRatio =
ShareholderEquity

If a company with DCA uses its retained earnings to buyback shares, the Debt to Equity
Ratio will be very high
This gives the wrong perception that the Company is using debt to finance operations
Financial institutions have very high debt to equity ratio due to the nature of their
businesses

Shareholder's equity/Book value

- Preferred stock

- Common stock

- Additional paid in capital.

Common Stock holders are the owners of the company and have voting rights

Preferred Stock holders do not have voting rights. They, however have right to dividend
before common stock holders.

Common and preferred stocks are mentioned at face/par value in balance sheet.

eg: face value = $1 but if it is sold to public for $10 then, common stock - $1, paid in capital =
$9

Companies with DCA tend not to have any preferred stock.

Retained Earnings

- A company with DCA to make additions to its retained earnings. It should be at a

somewhat consistent growth rate

- Eg: coca-cola has been growing its retained earnings pool for the last 5 years at the rate of
7.9% per yr.

- It's important to check why retained earnings are negative. eg: Microsoft uses it entirely to
pay as dividends and buybacks.

Treasury Stock

When a company buys back stock, it can,

1) Cancel it

2) Retain and Re-issue later. This is recorded under treasury stock as a negative value.

So check if ROE is due to financial engineering as per 2) or exceptional business economics

Return on Shareholder's equity

3 sources

1. Originally raised capital of preferred and common stock (IPO)

2. Later sales of preferred and common

3. Accumulated Retained Earnings

N etEarnings
ReturnOnEquity(ROE) =
ShareholderEquity
Companies with DCA show higher than average ROE eg: Coca cola-30%, Wrigley's-24%

Companies with a long history of strong net earnings but negative shareholder's equity is a
company with DCA

This is because they use all retained earnings as dividends or to buy back stocks

Problem of Leverage

Avoid businesses that use a lot of leverage eg: An investment bank borrows at 6% and lends
the same at 8% while it makes profit, it becomes a problem when the money which is lent
defaults

Profit and Loss Statement

Revenue

By itself does not say much.

Cost of Goods Gold / Cost of Revenue

- the lower the better

Note: Purchase of Stock In Trade. This is the purchase of finished which are either used to
make the finished product or sold as is goods

Gross Profit

Revenue minus cost of raw materials + labour to make the goods.

Does not include

- Sales & admin costs

- Depreciation pin

- Interest cost/finance

- R&D

Gross Profit Margin = Gross Profit/Total Revenues.

- 40% or better gross margins indicate DCA

- Track for last 10 years

Operating Expenses

- sales & admin costs.

- depreciation

- interest cost/finance cost

- R&D.

As per general consensus Operating Expense does not include interest cost. Taxes are
excluded since it is outside mgmt control. Interest Expense is excluded since it is a financing
decision. But I disagree that it should be excluded.

Operating profit or loss

Gross profit - Operating Expenses.

SGA costs Selling, General and Administrative Costs

Note: Companies that don't have a DCA. Suffer intense competition and show wild variation
in SGA costs.

Lower the SGA the better

Less than 30% of gross profits as SGA expense is good

R&D costs

- Companies that spend heavily on R&D have an inherent flow in their competitive advantage
that will always put their long term economies at risk. eg. Intel

- Little to no R&D is good

Depreciation

- EBITDA ignores the fact that eventually the capital equipment will wear out and has to be
replaced

- Depreciation should always be considered Ian expense and included in earnings

- Depreciation expense less than 10-15% of operating profit

Interest Expense

- This is the interest paid out on the debt of the company

- Interest expense for company with DCA would be less the 15% of operating income.

- What is considered average or good varies industry to industry

- Eg: banks will have high interest expense

Gain/ Loss on Sale of Assets

- The gain/loss on the value left after depreciation

eg: a plant/machinery which has been sold

Income before tax

Income after taxes paid

Deduct tax % (eg: 30%) from income before tax. Check if it is approximately matching the
taxes paid in the year.

Net Earnings

- Income after all expenses and taxes. Net Earnings should show historical a upward trend.

- Anything more than 20% earnings on revenue is good. exceptions banking/financial

companies.

Per Share Earnings

- Net Earnings / No of Shares

- Shows consistency and upward trend over 10 year period

Cash Flow Statement
Most Companies use accrual method of accounting i.e., sales are booked when goods go
out the door, even if buyer takes years to pay back

Hence a cash flow statement is used to record actual cash inflow and outflow.

A. Cash from Operating Activities.

Net Income (+)

Depreciation (+)

Amortization (+)

B. Cash from Investing Activities (-)

Capital expenditures (-)

Other investing cash flow (-)

C. Cash from Financing Activities.

Payment of dividends

Selling/buying of stock.

A + B + C = N etChangeI nCash

Capital Expenditure

50% or less capital expenditure to earnings is good

Compare earnings per share to the expenditure net per share. eg: coca-cola earned
$20.21 per share while using only $4.01 per share for capital expenditure ie 19% of
earnings
Add capital expenditure of 10 years and compare to net earnings of 10 years.

Stock Buyback

- A tax free way to increase the value to a shareholder

- Dividends while adding value, are also taxed

- A company with DCA would have a history of buybacks