Monday, December 22, 2014

The first 2 questions to pop up after reading annual reports

1. How does the company make money?

Easily, you can gather the nature of the business (what the company sells) through the company website. However, it’s not just about the products and services but how does the company actually make money? To illustrate an example, I will use Straco Corporation Limited (“Straco”), Annual Report FY2013. Straco is operates and manages tourist attractions.

Please note that this is not a recommended stock pick. Seek your licensed financial consultant for advice. Any information below is used for educational purpose.

Firstly, find out:

“Where did the company sales originate from?”

“Which segment contributes the most to the company’s sales?”

To get the answers, dive into the income statement of the annual report. Look at the revenue portion. You will get the figures in 2012 ($55,198,435) and 2013 ($72,840,387). Write the figures down on a piece of paper.

Notice that there is a “Note” section, just beside Year 2013. Notes to financial statements are important to explain how the numbers are derived. Sometimes, you see the numbers are “hard to believe” while some looked reasonable.

And that’s where you need to investigate further by referring to the points. In this instance, flip to the section on “Note 16” to understand the different segments of revenue.

The section reveals ticketing, retail, food and beverages and production service fee (who does the company earn from). Next, state the highest portion of revenue. It’s ticketing with $52,626,142 in 2012 and $69,170,152 in 2013. In other words, you have answered the question on “which segment/buyer contributes the most to the company’s earnings?”

2. How does the company spend money?

Like any businesses, a firm uses their capital to hire people, set up their operations and buy relevant equipment. A company sets a budget for carrying out their work annually. A percentage of funds are allocated for each activity and it will be reviewed periodically or once per year.

Certainly, from the investor perspective, you will not prefer a firm to overspend, buy unnecessary stuff or underspend. Ideally, there should be a balance, in consideration of the business plan. If the company spends excessively, without back-up financial gateway, the firm will be trapped in cash flow problem. Contingencies are vital, just like an individual’s Career Exit Plan

For example, it’s logical to debate that a new retail shop shall remain financially conservative in the first year. Capital is raised to buy merchandises, pay for the initial shop’s fit-outs and rental costs, including wages. Hence, the objective is to reach the break-even point. That said, it’s advisable to spend creatively. Reach a certain level of awareness to a target group of consumers and this involves money - without using more than half of the shop’s start-up capital. If their total sales proceeds are weak and total expenses accrued more than three quarters of sales, at the end of the year, the shop may face losses. To an investor, that’s not good news. So, a good look at the expenses is useful.

Therefore the next sets of questions to think are

“how is the breakdown of expenses like?”

“which is the highest expenditure in the last 3 to 5 years and has the company spend it wisely?”

“Do the expenses make sense in proportion to their business?”

Turn to the income statement again. Look at the “expenses” section.

There are 2 segments. One is operating expenses and the other is administrative expenses. What makes up each of them?

Let’s refer to the “Note 17” column.

Wages and salaries (staff costs) make up the majority of the expenses. Since Straco is in the business of tourist attractions, a bigger pool of manpower is needed to provide excellent service and memorable experiences – for instance, someone to manage the ticketing counter and another to maintain the cleanliness of the premise. While this constitutes the most, Straco has kept other expenses in check, as seen in the diagram below. Straco is in the leisure industry which is susceptible to macroeconomic shocks and unforeseen natural disasters.

Rationally, the logic makes sense. For a deeper analysis, an Investor is able to pull out a similar company (in the same industry) to cross-compare the majority of the expenses and whether the company is spending money wisely.

Assume, on average for the past 5 years, a company earns S$10 million and net profit is S$1 million. An Investor has to ask where the S$9 million goes to. If the company spends it on fancy office premise and purchases a yacht, on the pretext of looking “good” to draw more business, probably the firm should have a better way of spending money.

Should the company is in the IPO stage, naturally the company will not have 3 to 5 years track record. The Investor will look at other companies of the same nature or interpret based on judgement call – and a little common sense.

Walk away if you are unclear how the company earns money and how money is spent.

Chances are, you will be swept away by the glossy pages of the annual reports. It’s best advised to look at another company.

If you need an easy-to-use document - “how does the company make money” - please feel free to fill in the "contact me" box, found on the right hand side of my blog (scroll down the page). I’ll send you a free copy of my worksheet.

There are a few self-probing questions which may be useful for beginners.

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