A couple weeks ago Warren Buffet wrote an opinion piece that was subsequently syndicated across many different news outlets, a link follows below. The basic guise of the article is to thank government for stepping in to avert the financial meltdown that was occurring in 2008 and still is occurring and will continue to occur for at least the next couple years when no one else would or could have. Although the government is wasteful at times and often messes things up it did pull through in a big way during the crisis.
http://www.cnbc.com/id/40229527/Warren_Buffett_s_Letter_to_Uncle_Sam
Tuesday, November 30, 2010
Friday, November 12, 2010
Income Statement Basics - FS - #2
This is going to be long, its going to be painful but sometimes that's what you have to do to learn something, in this case the "Income Statement." Everything takes effort, just like efficient markets hypothesis says in regard to people that spend their entire life looking for outsize returns - they get those returns, but at the expense of all the time spent looking for them. So if you want outsize returns you are going to have to put in your time, so get comfortable and stay alert for this one. Ohh, and by the way, we are starting simple to make sure no one misses anything, but pay attention things will get more difficult.
We've already discussed in brief that there are three main financial statements: 1) Income Statement, 2) Balance Sheet, and 3) Statement of Cash Flows - there is a forth 4) Statement of Stockholder's Equity but it is used much less in financial statement analysis. At some point in the future I'm sure I will discuss it, but for today we will do a quick run through the income statement.
Below is an extremely simplified "Income Statement," but it demonstrates the flow of how the statement operates (remember in finance the parenthesis mean minus/subtract/negative).
So the basic "Income Statement" just has us taking sales and subtracting costs to get us to net income. We have some amount of sales that generates a swath of money, then we take away all the costs that it took to generate those sales, if anything is left over, we have a profitable business and will hopefully stay in business.
The tricky part is that this process involves accruals (to be discussed), and in reality there are many different costs within the statement. Of that myriad of costs some that matter a lot for our analysis and some are not as important. Some of those costs can be tips that a company may be engaging in some not so conventional activities which could scare us away while others may not give us much information at all.
Below I have set up a slightly more complex "Income Statement" that we can go through line by line. There are major sections to the statement that each contain many costs under them. There are multiple lines in an it that are breaks to create stopping points before taking out additional costs (italics). At each of these steps we can understand certain aspects about a company that may give us key insight into where a company excels and where their profits are getting eaten up.
As you look at the monster below which we will refer to multiple times, do not get worried, I will explain step by step what we are looking at, take a general look for a minute but do not try to understand everything - that's why I'm here! And remember, all "Income Statements" are different, I can prepare you for a lot but at the end of the day there is a reason you can't automate financial statement analysis: all financial statements are different and all have multiple moving parts that taken singularly may mean little but taken together can paint a striking picture of a company.
Yes, it appears daunting but lets first look at the main sections and see what each of them contain.
The first section is listed as "Operating Expenses," it by far paints the most important picture of the nuts and bolts of whether a company is working well or not. But there is one step before that, after our sales line we take out something called "Cost of Goods Sold" or "COGS" in short. This is just what it sounds like, and includes the materials, labor, and manufacturing overhead (all costs included in making the actual good sold). You won't see this in a service company. After you take away "COGS," you end up with "Gross Profit," or the profit you make on the items you have sold before taking away any other corporate expenses, selling expenses, financing costs or taxes. This shows how profitable your actual products are before other costs.
Anyways, back to "Operating Expenses." These are all the "normal" costs of a company (after COGS of course), they include any "Administrative" or "Selling" expenses (which you can think of as subsections of "Operating Expenses." There are a few examples of "Administrative" and "Selling" expenses under each heading that should be self explanatory.
By now you should be noting that company's have many different costs, costs that eat away at that dollar that you dropped in the top of the IS (income statement) when you initially made your sale. That is why you often hear about cost cutting as a way to increase profitability, that is one of only two ways to increase net income - the other method is to increase sales.
Increasing sales helps profitability because some costs are fixed and some are variable, as sales increase the cost of goods sold is spread over fixed costs which makes each additional dollar in sales more profitable than the last. This is something we will also hit more on later.
At this point in time before discussing our next category of costs it is important to note that the further we move down the income statement the more infrequent each cost becomes. Most company's will always have the costs we've talked about above; however, some of the costs we discuss that are further down the "Income Statement" are less common and may not occur every quarter. This is something that many people don't understand.
A simple check here is to be sure that some of the costs at the bottom of the IS that we discuss below shouldn't be occurring every quarter. Executives know that many analysts ignore these costs and thus may try to hide normal costs in them knowing that analysts will focus more on top of the income statement costs (remember executives are always trying to move around costs so always be skeptical). If you are still with me we will continue on...
We just got down to our "Operating Income" line. We have taken out some basic costs of what everyone knows it takes to run a company (well in general at least). Now we are going to take out some "Other" stuff, literally. Next we take out out the category "Other Expenses/Losses," and add in "Other Revenue/Gains." Here we would be removing expenses or losses that aren't related to our core business and adding in additional revenue of the same nature (not core revenue).
Think of it like this, Walmart does not exist to invest in other companies and get dividends; however, from time to time it may strategically purchase shares and receive dividends, this isn't related to Walmarts core retail operations but is still added to get to net income. In addition, Walmart may have debt outstanding that it pays interest on, interest isn't related to the core selling or "Operating" business of Walmart but does have to be deducted before getting to net income. If you are quick reader you will also recall that we have moved further down the income statement and these costs may not occur every quarter; however, companies very frequently own shares in other companies and have debt issued to finance operations, so most large companies will have these items.
After taking out all of the expenses to this point we have arrived at "Income From Continuing Operations," which is again pretty much what it sounds, all these costs are common and frequent and should occur on a continual basis. Now will now look at a couple "weird" costs before getting to our goal, "Net Income."
Next we deduct "Losses from Discontinued Operations." When a company decides to get out of a certain business or close a store that isn't profitable this is where the costs of that series of events ends up. "Losses from Discontinued Operations" is a hodgepodge of costs related to moving merchandise out of stores that are closing, literally nailing the doors shut, selling the property and so on. Frequently these are estimated and the cash actually moves through the "Statement of Cash Flows" at different times, but at this point you just need to know these are expenses from closing certain stores, segments or divisions of a company.
With large companies, like Walmart, expenses from discontinuing operations will pretty much be a perennial occurrence - so seeing them over than over doesn't have to spook you. Very large companies are always engaging in new ideas, some that work and some that don't, when one doesn't work it gets cut after a period of time and this is where the costs of that "cutting" end up. Do your homework though, look for large spikes in these expenses or continued growth in the size of this expense account, this could be a sign that a company is trying to hide other expenses here or is engaging in lots of projects that are not panning out.
We are now left at the line "Losses Before Extraordinary Items." In accounting lingo, "Extraordinary Expenses" are any expenses that are infrequent and unpredictable, or something like that. In my example "Income Statement" I put "Earthquake Expenses." This would include expenses related to damage caused by an earthquake. However, these may not even always qualify if your stores are based in earthquake prone zones, then the expense may just be put in "Other Expenses," after all, earthquakes on the San Andreas fault are not that rare. To drive the point home "Extraordinary Expenses" are so rare that accountants are thinking of phasing the section out of "Income Statements" in general. In other words, you shouldn't see stuff here, EVER!
Folks we are almost at our destination! We have sliced out all sorts of costs but there is still one cost that hits all companies, "TAXES." In the next step we take out taxes, which sounds straightforward but isn't at all in reality (again for later), and end with "Net Income." Now for some important caveats.
An important thing to remember is that the "Income Statement" does not necessarily represent money that was collected and paid out. The income statement is showing expenses that occurred over a period of time, a quarter, half or year. The income and expenses are shown on the "Income Statement" because the transaction that created them occurred during that period, even though the cash collected or paid may not occur until much later. Sounds odd but it isn't that complex, although it creates many complexities for accountants.
A company may make a large sale on credit during the first quarter and the entire sale would be listed in the sales number for that period; however, the cash collected may not show up in the "Statement of Cash Flows" until the second quarter. A company could also prepay a years rent and it would show up in the "Statement of Cash Flows" when paid, but again if the rent was only for the first quarter only a portion of that rent would show up in the "Income Statement."
This makes the important point of why we must review the financial statements as a unit and not base decisions on information garnered from just one financial statement. A company may be generating stupendous sales numbers but they can still run out of cash if they are extending credit out in the future to make those sales.
Once we get through the "Statement of Cash Flows" and the "Balance Sheet" it will all make sense. We haven't really performed too much analysis here but at least when you look at an income statement you can start understanding how it is organized. In addition, it is important to remember that all "Income Statements" are slightly different. With GAAP (Generally Accepted Accounting Principals [the system used within the United States]), there is some leeway as to how financial statements are presented and thus we get differences which I can't prepare you for, but you now have the structure to be able to gauge where they go and whether they are important or not.
One more point is to start simple in your analysis and DO NOT start with an insurance or financial company. Banks do accounting in very different ways and the "Income Statement" will not make sense based on what I have just told you. As usual I would recommend starting with something like a manufacturer or a retail company to wet your teeth.
In the future we will discuss our other financial statements, following that we will do some ratio analysis on our statements and then look at red flags that may show something undesirable is going on within the company - finally we will tie it all together by looking at how the statements interact with each other and flow together.
As always, feel free to email me with any questions you may have on any of this...sorry for the monster post but hopefully you were able to learn something.
We've already discussed in brief that there are three main financial statements: 1) Income Statement, 2) Balance Sheet, and 3) Statement of Cash Flows - there is a forth 4) Statement of Stockholder's Equity but it is used much less in financial statement analysis. At some point in the future I'm sure I will discuss it, but for today we will do a quick run through the income statement.
Below is an extremely simplified "Income Statement," but it demonstrates the flow of how the statement operates (remember in finance the parenthesis mean minus/subtract/negative).
So the basic "Income Statement" just has us taking sales and subtracting costs to get us to net income. We have some amount of sales that generates a swath of money, then we take away all the costs that it took to generate those sales, if anything is left over, we have a profitable business and will hopefully stay in business.
The tricky part is that this process involves accruals (to be discussed), and in reality there are many different costs within the statement. Of that myriad of costs some that matter a lot for our analysis and some are not as important. Some of those costs can be tips that a company may be engaging in some not so conventional activities which could scare us away while others may not give us much information at all.
Below I have set up a slightly more complex "Income Statement" that we can go through line by line. There are major sections to the statement that each contain many costs under them. There are multiple lines in an it that are breaks to create stopping points before taking out additional costs (italics). At each of these steps we can understand certain aspects about a company that may give us key insight into where a company excels and where their profits are getting eaten up.
As you look at the monster below which we will refer to multiple times, do not get worried, I will explain step by step what we are looking at, take a general look for a minute but do not try to understand everything - that's why I'm here! And remember, all "Income Statements" are different, I can prepare you for a lot but at the end of the day there is a reason you can't automate financial statement analysis: all financial statements are different and all have multiple moving parts that taken singularly may mean little but taken together can paint a striking picture of a company.
Yes, it appears daunting but lets first look at the main sections and see what each of them contain.
The first section is listed as "Operating Expenses," it by far paints the most important picture of the nuts and bolts of whether a company is working well or not. But there is one step before that, after our sales line we take out something called "Cost of Goods Sold" or "COGS" in short. This is just what it sounds like, and includes the materials, labor, and manufacturing overhead (all costs included in making the actual good sold). You won't see this in a service company. After you take away "COGS," you end up with "Gross Profit," or the profit you make on the items you have sold before taking away any other corporate expenses, selling expenses, financing costs or taxes. This shows how profitable your actual products are before other costs.
Anyways, back to "Operating Expenses." These are all the "normal" costs of a company (after COGS of course), they include any "Administrative" or "Selling" expenses (which you can think of as subsections of "Operating Expenses." There are a few examples of "Administrative" and "Selling" expenses under each heading that should be self explanatory.
By now you should be noting that company's have many different costs, costs that eat away at that dollar that you dropped in the top of the IS (income statement) when you initially made your sale. That is why you often hear about cost cutting as a way to increase profitability, that is one of only two ways to increase net income - the other method is to increase sales.
Increasing sales helps profitability because some costs are fixed and some are variable, as sales increase the cost of goods sold is spread over fixed costs which makes each additional dollar in sales more profitable than the last. This is something we will also hit more on later.
At this point in time before discussing our next category of costs it is important to note that the further we move down the income statement the more infrequent each cost becomes. Most company's will always have the costs we've talked about above; however, some of the costs we discuss that are further down the "Income Statement" are less common and may not occur every quarter. This is something that many people don't understand.
A simple check here is to be sure that some of the costs at the bottom of the IS that we discuss below shouldn't be occurring every quarter. Executives know that many analysts ignore these costs and thus may try to hide normal costs in them knowing that analysts will focus more on top of the income statement costs (remember executives are always trying to move around costs so always be skeptical). If you are still with me we will continue on...
We just got down to our "Operating Income" line. We have taken out some basic costs of what everyone knows it takes to run a company (well in general at least). Now we are going to take out some "Other" stuff, literally. Next we take out out the category "Other Expenses/Losses," and add in "Other Revenue/Gains." Here we would be removing expenses or losses that aren't related to our core business and adding in additional revenue of the same nature (not core revenue).
Think of it like this, Walmart does not exist to invest in other companies and get dividends; however, from time to time it may strategically purchase shares and receive dividends, this isn't related to Walmarts core retail operations but is still added to get to net income. In addition, Walmart may have debt outstanding that it pays interest on, interest isn't related to the core selling or "Operating" business of Walmart but does have to be deducted before getting to net income. If you are quick reader you will also recall that we have moved further down the income statement and these costs may not occur every quarter; however, companies very frequently own shares in other companies and have debt issued to finance operations, so most large companies will have these items.
After taking out all of the expenses to this point we have arrived at "Income From Continuing Operations," which is again pretty much what it sounds, all these costs are common and frequent and should occur on a continual basis. Now will now look at a couple "weird" costs before getting to our goal, "Net Income."
Next we deduct "Losses from Discontinued Operations." When a company decides to get out of a certain business or close a store that isn't profitable this is where the costs of that series of events ends up. "Losses from Discontinued Operations" is a hodgepodge of costs related to moving merchandise out of stores that are closing, literally nailing the doors shut, selling the property and so on. Frequently these are estimated and the cash actually moves through the "Statement of Cash Flows" at different times, but at this point you just need to know these are expenses from closing certain stores, segments or divisions of a company.
With large companies, like Walmart, expenses from discontinuing operations will pretty much be a perennial occurrence - so seeing them over than over doesn't have to spook you. Very large companies are always engaging in new ideas, some that work and some that don't, when one doesn't work it gets cut after a period of time and this is where the costs of that "cutting" end up. Do your homework though, look for large spikes in these expenses or continued growth in the size of this expense account, this could be a sign that a company is trying to hide other expenses here or is engaging in lots of projects that are not panning out.
We are now left at the line "Losses Before Extraordinary Items." In accounting lingo, "Extraordinary Expenses" are any expenses that are infrequent and unpredictable, or something like that. In my example "Income Statement" I put "Earthquake Expenses." This would include expenses related to damage caused by an earthquake. However, these may not even always qualify if your stores are based in earthquake prone zones, then the expense may just be put in "Other Expenses," after all, earthquakes on the San Andreas fault are not that rare. To drive the point home "Extraordinary Expenses" are so rare that accountants are thinking of phasing the section out of "Income Statements" in general. In other words, you shouldn't see stuff here, EVER!
Folks we are almost at our destination! We have sliced out all sorts of costs but there is still one cost that hits all companies, "TAXES." In the next step we take out taxes, which sounds straightforward but isn't at all in reality (again for later), and end with "Net Income." Now for some important caveats.
An important thing to remember is that the "Income Statement" does not necessarily represent money that was collected and paid out. The income statement is showing expenses that occurred over a period of time, a quarter, half or year. The income and expenses are shown on the "Income Statement" because the transaction that created them occurred during that period, even though the cash collected or paid may not occur until much later. Sounds odd but it isn't that complex, although it creates many complexities for accountants.
A company may make a large sale on credit during the first quarter and the entire sale would be listed in the sales number for that period; however, the cash collected may not show up in the "Statement of Cash Flows" until the second quarter. A company could also prepay a years rent and it would show up in the "Statement of Cash Flows" when paid, but again if the rent was only for the first quarter only a portion of that rent would show up in the "Income Statement."
This makes the important point of why we must review the financial statements as a unit and not base decisions on information garnered from just one financial statement. A company may be generating stupendous sales numbers but they can still run out of cash if they are extending credit out in the future to make those sales.
Once we get through the "Statement of Cash Flows" and the "Balance Sheet" it will all make sense. We haven't really performed too much analysis here but at least when you look at an income statement you can start understanding how it is organized. In addition, it is important to remember that all "Income Statements" are slightly different. With GAAP (Generally Accepted Accounting Principals [the system used within the United States]), there is some leeway as to how financial statements are presented and thus we get differences which I can't prepare you for, but you now have the structure to be able to gauge where they go and whether they are important or not.
One more point is to start simple in your analysis and DO NOT start with an insurance or financial company. Banks do accounting in very different ways and the "Income Statement" will not make sense based on what I have just told you. As usual I would recommend starting with something like a manufacturer or a retail company to wet your teeth.
In the future we will discuss our other financial statements, following that we will do some ratio analysis on our statements and then look at red flags that may show something undesirable is going on within the company - finally we will tie it all together by looking at how the statements interact with each other and flow together.
As always, feel free to email me with any questions you may have on any of this...sorry for the monster post but hopefully you were able to learn something.
Wednesday, November 10, 2010
Den of Thieves
From now and then as I finish a good book. Quite often I like to discuss small parts of it and recommend it to others, today I finished "Den of Thieves," a book by James Stewart. The book came out in the 1992 and chronicled the rise of high yield bonds (or the artist formerly known as junk bonds) and the art of the leveraged by out.
The main character is Michael Milken - the man who pioneered to leverage buyout through junk bonds while dominating his firm Drexel Burnham Lambert. Milken basically takes over the firm through the sale of junk bonds. As we know from past articles, at an investment bank the man who runs the bank is not the CEO but the guy that brings in fees - that man was Milken. To give you a taste of his earning power, he took home over half a billion dollars in payment (mostly bonus) in 1986.
"Den of Thieves" also discusses many arbitrage traders that along with Milken eventually were prosecuted for various insider trading and tax shelter schemes. Much of Wall Street including the likes of Kidder Peabody, Goldman Sachs, Drexel Burnham Lambert and various law firms were involved in the schemes.
One of the themes I noticed that by far isn't the main theme doesn't come in until the second half of the book. While members of the Manhattan attorneys office and SEC are trying to put together a case against different investment bankers you realize what they are up against. The various banks half millions of dollars to throw at lawyers and the number of law firms involved in the defense is mind blowing....the public side that is doing the prosecuting pales in comparison.
Many meetings are held at hotels where law firms would buy out entire floors to set up shop. In one scene from "Den of Thieves," as lawyers from the attorneys office are discussing arrangements with private lawyers the private lawyers order lunch. Looking at the prices including a $12 hamburger the members from the attorneys office decide not to eat, although they are very hungry. They also are forced to stay in sub-par hotels that fit their government stipend and their victory celebration at the end of the trials is held at a small inexpensive restaurant.
My point is that the book paints the picture of how hard it is to regulate Wall Street. This was during the 1980's and the junk bond fiasco very well mirrors the housing crisis, the products were just further down the food chain in our more recent case. Public regulators will always have trouble regulating Wall Street, the incentives aren't commensurate on the public side compared to the private side and the resources at ones disposal are nothing compared to the private sector. The question I would pose to you that is not discussed in "Den of Thieves," is how does one fix that?
The main character is Michael Milken - the man who pioneered to leverage buyout through junk bonds while dominating his firm Drexel Burnham Lambert. Milken basically takes over the firm through the sale of junk bonds. As we know from past articles, at an investment bank the man who runs the bank is not the CEO but the guy that brings in fees - that man was Milken. To give you a taste of his earning power, he took home over half a billion dollars in payment (mostly bonus) in 1986.
"Den of Thieves" also discusses many arbitrage traders that along with Milken eventually were prosecuted for various insider trading and tax shelter schemes. Much of Wall Street including the likes of Kidder Peabody, Goldman Sachs, Drexel Burnham Lambert and various law firms were involved in the schemes.
One of the themes I noticed that by far isn't the main theme doesn't come in until the second half of the book. While members of the Manhattan attorneys office and SEC are trying to put together a case against different investment bankers you realize what they are up against. The various banks half millions of dollars to throw at lawyers and the number of law firms involved in the defense is mind blowing....the public side that is doing the prosecuting pales in comparison.
Many meetings are held at hotels where law firms would buy out entire floors to set up shop. In one scene from "Den of Thieves," as lawyers from the attorneys office are discussing arrangements with private lawyers the private lawyers order lunch. Looking at the prices including a $12 hamburger the members from the attorneys office decide not to eat, although they are very hungry. They also are forced to stay in sub-par hotels that fit their government stipend and their victory celebration at the end of the trials is held at a small inexpensive restaurant.
My point is that the book paints the picture of how hard it is to regulate Wall Street. This was during the 1980's and the junk bond fiasco very well mirrors the housing crisis, the products were just further down the food chain in our more recent case. Public regulators will always have trouble regulating Wall Street, the incentives aren't commensurate on the public side compared to the private side and the resources at ones disposal are nothing compared to the private sector. The question I would pose to you that is not discussed in "Den of Thieves," is how does one fix that?
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