How Buffett Interprets the Income Statement

It is important to investigate further & drill down to detect what the quality of earnings are made up of and what the numbers intepret.

• Gross Profit Margin: firms with excellent long term economics tend to have consistently higher margins

• Durable competitive advantage creates  a high margin because of the freedom to price in excess of cost
• Greater than 40% = Durable competitive advantage
• Less than 40% = competition eroding margins
• Less than 20% = no sustainable competitive advantage
• Consistency is key 

• Sales Goods and Administration: Consistency is key. Companies with no durable competitive advantage show wild variation in SG&A as % of gross profit

• Less than 30% is fantastic
• Nearing 100% is in highly competitive industry

• R&D: if competitive advantage is created by a patent or tech advantage, at some point it will disappear.

• High R&D usually dictates high SG&A which threatens the competitive advantage

• Depreciation: Using EBITDA as a measure of cash flow is very misleading

• Companies with durable competitive advantages tend to have lower depreciation costs as a % of gross profit

• Interest Expenses: Companies with high interest expenses relative to operating income tend to be either: 1) in a fiercely competitive industry where large capital expenditure required to stay competitive 2) a company with excellent business economics that acquired debt in leveraged buyout

• Companies with durable competitive advantages often carry little or no interest expense.
• Warren’s favorites in the consumer products category all have less than 15% of operating income.
• Interest expenses varies widely between industries.
• Interest ratios can be very informative of level of economic danger. 
• Important: In any industry, the company with the lowest ratio of interest to Operating Income is usually the one with the competitive advantage.

• Net Earnings

• Look for consistency and upward long term trend.
• Because of share repurchase it is possible for net earnings trend to differ from EPS trend.
• Preferred over EPS
• Durable competitive advantage companies report higher % net earnings to total revenues. 
• Important: If a company is showing net earnings history greater than 20% on total revenues, it is probably benefiting from a long term competitive advantage.
• If net earnings is less than 10%, likely to be in a highly competitive business

The Income Statement Summary Table

	(DCA = Durable Competitive Advantage)	Comments
Gross Profit Margin	>40% = D.C.A. < 40% = competition eroding margins < 20% = no sustainable competitive advantage	Consistency is Key
SG&A (SGA as % of gross profit)	< 30% is fantastic Nearing 100% is in highly competitive industry	Consistency is Key
Depreciation (depreciation costs as a % of gross profit)	Company with moat tend to have lower %
Interest Expenses (interest expenses relative to operating income)	Durable competitive advantages carry little or no interest expense. Buffett’s favorite consumer products have <15%	Company with lowest ratio of interest to Operating Income = competitive advantage. Varies widely between industries.
Net Earnings (% net earnings to total revenues)	Net earnings history >20% = Long Term moat < 10% = in highly competitive business	consistency and upward LT trend
EPS	10-year period showing consistency and upward trend. Avoid erratic earnings pictures.	Consistency = sign products don’t need to change. Upward trend = strong

Read more on the Income Statement Analysis  on my previous post - http://intelligentinvestor8.blogspot.my/2014/05/income-statement-analysis.html

Or, take a look on How Buffett read other financial statements:-

• How Buffett Interprets the Income Statement
• How Buffett Interprets the Balance Sheet 
• How Buffett Interprets the Cash Flow Statement

References:-

• Uncovering How Buffett Interprets the Financial Statements - Jae Jun

Income Statement Analysis - APOLLO vs LONBISC

Table 1 and Table 2 in appendix presented the horizontal common size analysis of APOLLO and LONBISC respectively. It express the income statements in each year as a percentage of given base year (year 2009). Horizontal analysis on income statement help us to identify the trend of revenue, expenses and incomes from the previous year’s compared to the base year of 2009. 

We see that the APOLLO's revenue grew by 27% from 2009 to 2013 (CAGR of 6%).  And, the cost of sale grew at slight lower rate (21%) resulting in higher growth in gross profit (45%).  The more important operating profit and net profit grew at a higher rate of 66% and 53% respectively.  The profit growth is in tandem with revenue growth and the quality of growth is hence considered good.

LONBISC's revenue growth in a faster rate of 57% (CAGR 12%). This revnue growth is much more better than APOLLO. Isn’t LONBISC an ideal growth company to invest in? Not until after you have investigated the quality of its growth.

LONBISC's cost of sales increases at 72% and this is much higher than the revenue growth rate (57%) and this results a lower gross profit growth (18%). And, this further contribute to the lower growth of the operating profit and net profit. This prove that  the quality of its growth for LONBISC is very poor.

Table 3 and Table 4 in appendix presented the vertical common size analysis which let us see how the revenues and the spending on different types of expenses change from one year to the next for each company, and compare the two companies of different revenues.

The vertical analaysis on Income statement on APOLLO show us that the profit margin (gross, operating, and net) is on a steady up trend. And, the management’s ability to contain the total operating expenses to about 10% each year.  The growth in profit margin is in tandem with the revenue growth. On the latest financial year, the gross profit margin, operating profit margin and net profit margin is 28%,  19% and 14% respectively.  The good result here give us more confident on APPOLO's growth quality.

In comparison, LONBISC has a much lower gross, operating and net profit margin of just 20%, 10% and 5% in 2013. The more worrisome part is these margins was in down trend and have been deteriorating every year since 7 years ago. It is clear from the vertical analysis that the culprit is the unabated increasing cost of sales which has increased from 64% of sales from 2006, to 79% in 2013, whereas operating costs have not improved much despite the high growth in revenue as shown in Table 4 in the Appendix. 

Comparison between APOLLO and LONBISC, the total operating costs as a percentage of sales of LONBISC is generally 50% higher than that of APOLLO (15% vs 10%). The heavy financing cost of LONBISC (4%) worsens the net profit margin compared to the debt free status of company APOLLO . These explain the much better financial performance of company APOLLO in comparison with LONBISC.

Based on the analyst result, it clear show that chasing high growth is not necessary a good investing strategy, but searching for quality growth is. High growth unaccompanied by profit growth often could be a bogus growth.

Appendix:-

Year	2013	2012	2011	2010	2009		CAGR
Revenue	127.04%	114.38%	100.54%	90.99%	100.00%		6%
Cost of sales and services	121.13%	117.60%	102.91%	86.26%	100.00%		5%
Gross profit	145.14%	104.52%	93.31%	105.45%	100.00%		10%
Other operating income	119.78%	129.03%	100.13%	283.82%	100.00%		5%
Administrative expenses	121.80%	109.87%	113.08%	107.91%	100.00%		5%
Selling and distribution	113.71%	103.85%	76.69%	82.66%	100.00%		3%
Other operating expenses	79.62%	0.00%	129.33%	112.83%	100.00%		-6%
Profit from operation, EBIT	166.85%	112.39%	88.74%	126.75%	100.00%		14%
Finance costs	-	-	-	-	-		-
Share of profit from associate co.	-	-	-	-	-		-
EBT	166.85%	112.39%	88.74%	126.75%	100.00%		14%
Taxation	229.13%	151.46%	104.40%	167.35%	100.00%		23%
Net Income	153.38%	103.93%	85.36%	117.97%	100.00%		11%
Attributed to:
Equity holders of the company	153.38%	103.93%	85.36%	117.97%	100.00%		11%
Minority interest	-	-	-	-	-		-

Table 1: Horizontal Analysis of APOLLO

Year	2013	2012	2011	2010	2009		CAGR
Revenue	157.34%	137.56%	126.28%	121.23%	100.00%		12%
Cost of sales and services	172.04%	146.04%	131.03%	126.55%	100.00%		15%
Gross profit	118.42%	115.11%	113.71%	107.16%	100.00%		4%
Other operating income	385.86%	202.20%	180.42%	89.53%	100.00%		40%
Administrative expenses	157.50%	96.42%	101.23%	100.29%	100.00%		12%
Selling and distribution	138.50%	147.39%	125.82%	129.15%	100.00%		8%
Other operating expenses	-	-	-	-	-		-
Profit from operation, EBIT	122.01%	112.73%	119.60%	93.06%	100.00%		5%
Finance costs	115.95%	136.95%	124.53%	77.77%	100.00%		4%
Share of profit from associate co.	0.00%	0.00%	0.00%	78.21%	100.00%		-100%
EBT	106.68%	80.73%	98.08%	99.90%	100.00%		2%
Taxation	755.60%	92.67%	238.09%	-95.93%	100.00%		66%
Net Income	88.07%	80.39%	94.06%	105.52%	100.00%		-3%
Attributed to:
Equity holders of the company	77.14%	69.22%	76.88%	94.20%	100.00%		-6%
Minority interest	248.17%	244.06%	345.70%	271.39%	100.00%		26%

 Table 2: Horizontal Analysis of LONBISC

Year	2013	2012	2011	2010	2009	2008	2007	2006
Revenue	100.00%	100.00%	100.00%	100.00%	100.00%	100.00%	100.00%	100.00%
Cost of sales and services	-71.89%	-77.52%	-77.17%	-71.48%	-75.39%	-76.20%	-70.41%	-69.95%
Gross profit	28.11%	22.48%	22.83%	28.52%	24.61%	23.80%	29.59%	30.05%
Other operating income	1.20%	1.43%	1.26%	3.96%	1.27%	1.82%	3.24%	2.10%
Administrative expenses	-5.48%	-5.49%	-6.43%	-6.78%	-5.72%	-5.73%	-6.86%	-7.11%
Selling and distribution	-4.11%	-4.17%	-3.50%	-4.17%	-4.59%	-4.61%	-4.94%	-5.04%
Other operating expenses	-0.66%	0.00%	-1.36%	-1.31%	-1.06%	-1.83%	-1.52%	-1.49%
Profit from operation, EBIT	19.06%	14.26%	12.81%	20.21%	14.51%	13.45%	19.51%	18.52%
Finance costs	0.00%	0.00%	0.00%	0.00%	0.00%	0.00%	0.00%	0.00%
Share of profit from associate co.	0.00%	0.00%	0.00%	0.00%	0.00%	0.00%	0.00%	0.00%
EBT	19.06%	14.26%	12.81%	20.21%	14.51%	13.45%	19.51%	18.52%
Taxation	-4.65%	-3.42%	-2.68%	-4.75%	-2.58%	-1.87%	-3.60%	-3.94%
Net Income	14.40%	10.84%	10.13%	15.47%	11.93%	11.58%	15.92%	14.58%
Attributed to:
Equity holders of the company	14.40%	10.84%	10.13%	15.47%	11.93%	11.58%	15.92%	14.58%
Minority interest	0.00%	0.00%	0.00%	0.00%	0.00%	0.00%	0.00%	0.00%

Table 3: Vertical Analysis of APOLLO

Year	2013	2012	2011	2010	2009	2008	2007	2006
Revenue	100.00%	100.00%	100.00%	100.00%	100.00%	100.00%	100.00%	100.00%
Cost of sales and services	-79.36%	-77.06%	-75.31%	-75.76%	-72.58%	-75.02%	-66.71%	-63.48%
Gross profit	20.64%	22.94%	24.69%	24.24%	27.42%	24.98%	33.29%	36.52%
Other operating income	4.35%	2.61%	2.53%	1.31%	1.77%	1.96%	4.56%	3.34%
Administrative expenses	-6.09%	-4.26%	-4.88%	-5.03%	-6.08%	-3.79%	-5.84%	-6.63%
Selling and distribution	-8.20%	-9.99%	-9.29%	-9.93%	-9.32%	-10.09%	-11.12%	-10.15%
Other operating expenses	0.00%	0.00%	0.00%	0.00%	0.00%	0.00%	0.00%	0.00%
Profit from operation, EBIT	10.69%	11.30%	13.06%	10.58%	13.79%	13.06%	20.89%	23.09%
Finance costs	-4.21%	-5.69%	-5.64%	-3.67%	-5.72%	-7.24%	-7.72%	-5.79%
Share of profit from associate co.	0.00%	0.00%	0.00%	0.96%	1.48%	0.88%	-0.73%	0.01%
EBT	6.48%	5.61%	7.42%	7.87%	9.56%	6.70%	12.43%	17.30%
Taxation	-1.28%	-0.18%	-0.50%	0.21%	-0.27%	0.90%	-2.35%	-3.67%
Net Income	5.20%	5.43%	6.92%	8.09%	9.29%	7.60%	10.08%	13.63%
Attributed to:
Equity holders of the company	4.26%	4.38%	5.29%	6.76%	8.70%	7.60%	10.06%	13.18%
Minority interest	0.94%	1.05%	1.62%	1.33%	0.59%	0.00%	0.02%	0.45%

   Table 4: Vertical Analysis of LONBISC

References:-

• Income Statement Analysis
• Income Statement - Common Size Analysis
• A growth story of two confectionery companies kcchongnz