PERIOD ENDING 31-Dec-06 Total Revenue
Cost of Revenue Gross Profit
Operating Expenses Research Development
Selling General and Administrative Non Recurring
Others
Total Operating Expenses Operating Income or Loss
Income from Continuing Operations Total Other Income/Expenses Net Earnings Before Interest And Taxes Interest Expense
Income Before Tax Income Tax Expense Minority Interest
Net Income From Continuing Ops Non-recurring Events
Discontinued Operations Extraordinary Items Effect Of Account Changes Other Items
Net Income
Preferred Stock And Other Adjustments Net Income Applicable To Common Shares
863,180 517,885 345,295
19,254 164,174 457 - - 161,410
3,927 165,240 208 165,032 62,370 (166) 102,496
- - - - 102,496 -
$102,496
846,256 529,993 316,263
- 164,578 (2,044) - - 153,729
2,029 155,758 194 155,564 57,170 - 98,394
- - - - 98,394 -
$98,394
31-Dec-05 31-Dec-04 698,053 417,417 280,636
- 149,419 - - - 131,217
749 131,966 364 131,602 50,094 - 81,508
- - - - 81,508 -
$81,508
Starting at the top line
Sales or revenues make up the top lineof any business. Normally, sales and revenues are straightforward. They represent accounting dollars generated for business products sold or services performed. (Remember, with accrual accounting it doesn’t matter whether the company has been paid yet.) With more complex “b-to-b” businesses or for those selling into a distribution channel (a wholesaler or retailer), revenue recognition can be more complex.
Accounting revenue is normally recorded at the time of sale or service comple- tion. But there are situations in which the delivery process isn’t complete and may call revenue validity into question. If a distributor doesn’t have to pay until a product is resold, or if the manufacturer is still required to perform sig- nificant services, such as configuration, installation, or even warranty work, a sale to a distributor or customer may be exaggerated if fully recorded as a sale.
Similarly, sales to subsidiaries or affiliated companies shouldn’t be considered a sale. Sales for consideration other than money, such as advertising exposure, may also be suspect.
But for the most part, sales are sales. In many businesses, such as trans- portation or utilities, they may be called revenues, but it’s the same thing.
Occasionally you will see an allowance for returns broken out; if not, you can usually safely assume that they’re included in the sales figure as a negative amount. Most businesses don’t give breakouts on sales returns, not even in 10-K reports, because it isn’t required and it discloses competitive informa- tion, but it would be nice to see this detail.
When comparing sales figures or projecting trends, compare apples to apples.
If there is a significant acquisition, divestiture, or extraordinary change in the business, make sure to take it into account.
Cost of goods sold
Cost of goods sold, or CGS, is an important driver of business success. For all but a few companies with high intellectual property or service content, CGS is the largest piece of the revenue pie. Cost of goods soldis the cost of acquir- ing goods and raw material plus labor and direct overhead expended to add value for sale.
Different accounting treatments can affect CGS. Chapter 7 covers LIFO (last in, first out) and FIFO (first in, first out) as different ways of valuing balance sheet inventory. This valuation can also affect CGS — if more expensive LIFO raw material units are assumed to be consumed first, that will drive up the CGS and downthe gross margin, operating income, and net income. Hence, LIFO is the more conservative reporting method except in some technology industries in which older components may actually cost more. (Note 1 in the
financial statements usually clarifies accounting methods.) Value investors should be careful to understand which accounting method is used before comparing companies, and watch for changes in accounting methods that may shift reporting bias. In a price-stable low-inflation environment, the LIFO-FIFO thing becomes less important.
CGS varies widely by industry and industry cost structure. For example, the physical CGS of Microsoft is tiny with respect to revenue, whereas a grocery store or discount retailer may see CGS in the 70 or 80 percent range. Apples- to-apples comparisons and especially trend analyses are critical to effective business appraisal.
Gross margin
Gross margin,or gross profit,is simply the sales less the cost of goods sold. It is the basic economic output of the business before overhead, marketing, and financing costs enter the picture. Gross profit takes on added meaning when taken as a percentage. This percentage — and trends in the percentage — speak volumes for the health and direction of the business.
Operating expenses
You can’t make a joist hangar without a plant and a headquarters function and an IT department, and you probably can’t sell it either.
No matter the business, any company incurs indirect costs, or costs of doing business not directly related to producing and selling individual units of prod- uct or service. Some call it overhead, but it goes a little beyond the traditional definition of overhead and into marketing, R&D, and other costs necessary to sustain the business in addition to directly producing products.
Selling, general, and administrative (SG&A)
Selling, general, and administrative (SG&A) is a favorite target of value investors. SG&A includes marketing and selling costs, including advertising, sales and sales forces, marketing and promotion campaigns, and a host of other administrative and corporate expenses such as travel, Web sites, office equipment, and the like.
Many investors use SG&A as a barometer of management effectiveness — a solid management team keeps SG&A expenses in check. SG&A can mushroom into a vast slush fund and an internal corporate pork barrel that can easily get out of control. Like gross margin, looking at SG&A as a percentage is best.
For an example of SG&A analysis, see the “Practical example: SG&A at Simpson” sidebar.
Research and development
Manufacturing and technology companies in particular need to invest in future products. Because these investments occur long before product pro- duction, and because many of them never pan out into saleable products, companies are allowed to expense research and development (R&D) as a period expense.
Simpson, our example, does have a small R&D function with reported costs of $19.2 million, or about 2 percent of sales in 2006. No R&D expenses were reported in 2004 or 2005 in the Yahoo! Finance summary, but smaller figures do appear in the Simpson annual report. It is always a good idea to check actual company statements, although the difference in this case wasn’t really worth worrying about.
A few companies have been able to capitalizesoftware development costs; that is, build them into an intellectual property asset instead of expensing them, thereby inflating earnings. Accounting principles, aside from this exception, state that R&D costs must be expensed as incurred. There’s quite a bit of debate on this topic, for many R&D expenses have a long-term payoff and are key to building a business. Expensing them is a conservative accounting