Through my conversations with friends who are not in the field of finance/ starting out in investing, I notice that they often feel overwhelmed when they see a whole bunch of numbers. I look at financial statements and analyse numbers for a living and in my experience, numbers are just vehicles to tell a story. It’s never so much of what the number is, but what the number is saying. I stand firm by the quote ‘Numbers don’t lie’.
That is why it’s important to understand the significance of the many financial terms out there.
To invest, you must first be able to read financial statements.
To be able to effectively read financial statements, you must first know how to interpret them.
It then becomes your starting point to piece the business updates you read on the news. If not you’d just be catching up on all the business news but have no idea how that may impact the business you are investing in.
Which is why in this two-part mini blog series, i will expand on:
- Profitability ie. Income Statement
- Affordability ie. Cash Flow Statement [Part 2]
These terms will help you make sense of the financial results before you choose to invest in a business. Best part is, you don’t have to be an accountant to know them. 🙂
The key takeaway to remember is for all these financial terms, it’s always best to compare it :
- Over a period of time (ie. Company’s past performance)
- With its competitors
Think of it like when you want to improve a certain skill of yours – maybe video editing. First, you must compare how are you doing against your past self. Maybe you can tackle more complex video edits now. That indicates growth against yourself. The next level is to compare it with your peers; how does your skills measure up and what can you improve on. It’s the same with a company 🙂
So, here are Profitability-centric Financial Terms every beginner investor should understand:
This is the first up on the list because it indicates how much a company is earning through the sales of its product. If you ain’t got no sales, you ain’t got no business.
Mathematically, Revenues are Sales Price x Sales Volume, expressed in dollar terms.
It’s also known as ‘Top Line’. You will often hear things like ‘Growing our Top Line’. That’s just a fancy way of saying Growing our Sales.
Why is this important?
- It indicates there is demand from the market – rising revenues over a period of time indicates there is growing demand from the product
- It indicates the effectiveness of the company’s sales strategy – either through good price points or effective marketing campaigns or even expansion to sought out new customers. By comparing the trend of revenue against the competitors, it sheds light as to how effective the company is in expanding its market share (ie. maybe eating into competitor’s revenues)
2. Gross Profit & Gross Profit Margins
I lumped both under the same point because I regard them as the same, just one in absolute terms (Dollar value) vs one in relatives term (%) [ie. relative to the Revenue the company is earning].
Mathematically, Gross Profits are = Revenues – Cost of Good Sold [COGS] &
Gross Profit Margins % are = Gross Profits / Revenue; expressed in %
Cost of Goods Sold here means the direct cost that a company has to incur in order to sell its products. Example, you are a baker who sells cakes. So your cost of goods sold are the direct material cost that you incur to sell this cake eg. The flour, the butter etc. If you don’t incur this cost, you have no product to sell.
Assume your cake business earns revenues of $10k, and your COGS is $4k, this gives you a Gross Profit of $6k and a Gross Profit Margin of 60% [Gross Profit of $6k / Revenues of $10k]. So, assuming Revenues stay stagnant – the higher the COGS, the lower your Gross Profit and Gross Profit Margin and vice versa.
Why is this important?
- To identify the efficiency of a company in managing its direct cost. Imagine a company’s Gross Profit Margins are only 60% when the rest of its competitors are averaging at 70%. This is a sign that a company could be less efficient than its peers, OR it could indicate that the company is using more premium materials and therefore able to sell more. That’s why it’s important to assess it in both dollar terms and relative terms %.
- Also let’s not forget there are OTHER costs in a business still (more on that later) so if the Gross Profit Margins are already low to begin with, it leaves little space to absorb other indirect costs.
3. Operating Profit
The difference between Operating Profits and Gross Profits are the other indirect costs that is needed to run a business. We usually call these Overhead costs. Some notable indirect costs are:
- Fixed expenses such as salaries, office rent; which is payable regardless of whether any products are sold
- Depreciation cost – this is just an accounting way of accounting for large once off purchases like machines. The best way to think about it is like if you bought a laptop for $3k, you will usually tell yourself, ‘That’s not too expensive! If I use it for 10 years, it only costs me $300 per year!’. What you just did was depreciation. Allocating cost through it’s useful life so it’s actually reflective of cost you truly incur for a period.
- Selling and Distribution expenses – this is not a direct cost because often times your products could be shipped in bulk, so it can’t be directly attributed to the cost of making the product
So, Mathematically, Operating profits are = Gross Profits – Other Operating Expenses – Depreciation &
Operating Profit Margins are = Operating Profit / Revenues; expressed in % terms
Why is this important?
- Most overhead costs are payable regardless of whether you sell anything or not. So the higher those costs are, the more at risk businesses are during an economic downturn. That’s why, in this recent pandemic there were waves of retrenchment and Governments were giving rental moratoriums because it’s to relieve businesses of its fixed expenses. So if the Gross Profit Margins are a healthy 60% and suddenly the Operating Margins are a measly 20%. You know that’s a problem. Which means out of the $6k you earned from selling goods, $4k is going to paying just your overheads.
4. Profit After Taxes [PAT] & Net Profit Margins
Oh this is a big and arguably one of the most important ones because it doesn’t matter how many sales you can make, what’s most important is what you are left with at the end of the day. And that my friends is your PROFIT! If you are too lazy to read any of the rest, at least check this one out.
Between Operating Profit and Profit After Taxes are typically:
- Interest Expense – these are usually cost of serving debt (if there are any), which are also payable regardless of whether you sell any or not
- Taxes – in life, only two things are certain – Death and Taxes LOL. Though if you aren’t making any money that year, you don’t typically have to pay any
Mathematically; PAT = Operating Profit – Interest Expenses – Taxes
PAT Margins or Net Margins are = PAT/Revenues ; in % terms
Why is this important?
- To assess how much money is available for reinvestment to the business (to continuously grow) and for distribution to its shareholders. Most of the time, companies that pay out dividends have dividend policies which dictates how many % of it is to be distributed as dividends. The more money the business has left, benefits YOU as an investor now (through dividends) and in the future (through Growth in Value and potentially more dividends!)
- To assess how much a business’s profits are used to repay interest. The interest is true especially for businesses that take on a lot of debt to fund their operations/growth. Debt is not necessarily bad but it is fixed. And if a huge chunk of operating profits are used to make interest payments – that’s a problem.
5. EBITDA – Earnings Before Interest, Taxes, Depreciation & Amortisation
Okay don’t be put off by it’s long name, actually mathematically EBITDA is just
EBITDA = Operating Profit – Depreciation & Amortisation
& Amortisation and Depreciation is pretty much the same thing. Amortisation is a method of allocation for intangible assets (eg. trademarks) vs Depreciation which is for tangible assets (eg Equipment).
Why is this important?
- EBITDA is viewed as the proxy for cash flow within the income statement. You may wonder, why can’t we just use cash flow then? We can’t because cash flow is dependent on various factors like timing of collectability, so the best way to gauge the ‘cash’ impact for the period is using EBITDA
- EBITDA is used in several ratios notably Interest coverage ratio. Remember I mentioned how paying high interest could be problematic if earnings aren’t sufficient? EBITDA is the best measure to compare because it’s not propped by ‘non-cash’ earnings/expenses such as depreciations or on-paper gains.
& That wraps up Part 1 on Profitability! Stay tuned for Part 2!
Do let me know if you found these useful and if you want me to elaborate on more financial terms, would love to hear back from you 🙂
For more financial tips, check out the other articles under the ‘Lets Talk Money’ blog series.