Locating the source of profits.
By Nicholas Morris
October 7, 2013
In line with our goal to locate opportunities for short-term investments for your business, we've discussed low short-term rates will remain for some time. With the economy struggling, business owners should identify with other companies that are market leaders. It’s not enough to know a company is profitable. We need to identify the source of the profit. One credible source of information is the statement of cash flows. Here we can see what is driving income. Browsing financial statements is fine, but take it a step further and read the Notes or Management's Discussion and Analysis when you want answers. Find and identify the path of revenue.
All financial statements are not created equal. Investors want and need a systematic way to take accounting information and turn it into a digestible story of events that clearly illustrate a company’s performance. One underlying theme is to validate earnings. If we can locate the company’s Statement of Cash Flows we get a closer look into the source of income. Check to see if earnings reported is substantiated by revenue generated for the period, hence operating income. If the revenue is not generated by sales or service, did the boost come from a one-time sale of company assets? Did the company sell off land, equipment, or maybe a division? Management has some flexibility with the reporting process. The key is to identify underlying trends and know how to locate the source. If you’re not familiar with the SEC website, you can search the Next-Generation EDGAR system to check on your favorite company using their stock symbol. Look for a blue Interactive Data button
in the top box near the bottom and click. The left hand column is expandable and will contain multiple categories for further investigation.
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| Have you seen my accrued revenue? |
Unlike cash-basis accounting, accrual-based revenue is recognized when realized or realizable (cash is collected or expected to be collected) and earned (goods or services have been delivered or provided).
In accordance, under the matching principle, expenses are recognized in the same period as the matching revenues. However, accrual-based accounting requires the use of judgment and discretion by management when estimating how much revenue will be noncollectable. How much will product returns cost the company? How much will the company have to refund to their customers? What will the product’s warranty costs amount to? Also included in the list of options is: depreciation allowances, inventory, deferred taxes, and intangible assets like goodwill, write downs, gains and losses.
Quality of Earnings
The cash flow statement reports cash as operating, investing, or financing; and discloses explanations in the Notes to Financial Statements. When looking for performance issues, it is important to understand how operating cash flow relates to the company’s operating earnings. Did the company have a higher earnings number due to an increase in sales? Earning quality refers to the company’s use of depreciation methods, doubtful accounts, and unearned revenue. The degree can vary from conservative which decreases current earnings, to a more liberal use which might inflate earnings which should create some skepticism from investors. Sooner or later unearned revenue will become earned or will be written off, thus eliminated. These methods are self-correcting because the accounts have to balance.
Apple Inc.’s Statement of Cash flows is a great example of a company with a lot of cash and a lot of options. Their operating cash flow comes from sales and service. Cash flows from investments comes from and goes to business acquisitions, the purchase of property, plant, and equipment, and intangibles. Cash flows from financing come from and go to the sale of stock and the distribution of dividends. Borrowing money to buy back company stock is common when cash levels remain high and stock prices are at a discount.
The cash flow statement begins with net income from the income statement. Adjustments are made to eliminate non-cash revenues and expenses from operating activities, (i.e. depreciation is a reduction in asset value from use and not an expense). The next two categories include balance sheet items from investing activities (the purchase or sale of property, plant, and equipment) and financing activities (long-term borrowing, dividends) are totaled. These three activities are then added together to produce the years total cash and cash equivalents balance.
With EDGAR, we can identify and investigate the transactions by entry by looking to the Notes. The structure is layered for drilling down to the information you need. For example, under investing activity, Apple acquired intangible assets for $1,107 mil. The breakdown consists of amortizing the assets by class and duration. The categories are fairly self explanatory.
This Weeks Formula is Accrual to assets ratio.
Accrual to assets ratio =
Change in Working Capital - Change in Cash - Change in Depreciation
Change in Total Assets
Next time: How to determine earnings quality.
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