Guru Mantra 16- Competitive Advantage: Racing for Uniqueness (The Second Part)

Guru Mantra 7- Profit is NOT Cash

PL provides the most important health of a business that is profitability. Remember it does not tell you the financial health (a combination of income statement and balance sheet will tell us about financial health).

Please note PL doesn’t tell anything about cash either.

In other words PL is what is sold in a particular reporting period minus what is the cost to make these sales minus other expenses required for sales is equal to profit for the period.

Sales are recorded when company delivers the product or remit the services. Customer will have an obligation to pay and company will have a right to collect. When a company sends a bill company establish a right to collect but may be or not record sales. Simple reason sales is revenue which is recognized by accounting principle, and invoice is a contract note enforce a execution of negotiable instrument.

Costs are expenditure for raw materials, salary, overhead expenses, these are necessity when you a buy a products for inventory. When you ship the inventory, the total cost taken out for inventory and recorded as costs of goods sold. Cost will result lower bank balance and increase inventory values in balance sheet.

Gross margin is the amount left from sales after cost of goods sold is subtracted. It is also called gross profit, you can call the “manufacturing margin”. Helpful to analyze when a seller, manufacturer , buyer are all different people.

Expenses for selling, developing products or even general and administration aspects of the business. Few example would sales people salary, advertisement, legal feels, Research and development etc. Expenses reduces the income. Profit and income are same thing.

Operating expenses are those expenditures which company need to make income. E.g. sales and marketing, R&D, G&A. In US they called it SG&A, and in India very difficult to find easily. You need to calculated your own, so for same reason do not rely much the numbers published by various websites.

Operating income is gross profit minus operating expenses. Operating will exclude all other income like dividend received, interest etc.

Non operating income and expense are like paying interest on loan, receiving interest. They are not shown under revenue from operations.

Net profit is operating income minus non operating expenses plus non operating income.

We spoke about accrual accounting earlier , this means the timing between raising a bill and receiving cash differs and our financials is recorded on accrual basis.

Cash flow statement tracks the movement of cash through the business. Imagine your good old cheque book, where you use to write cheque number, money in and out. Cash flow is exactly the same.

Cash on hand at start of a period PLUS cash received MINUS cash spent EQUALS cash on hand at end.

Cash transactions all we know like paying salary, paying loan, purchasing goods. All these will reduce cash. On other hand we collect from customer, take loan which will increase cash.

Non cash transactions are those activities where there is no movement of cash. Like receiving goods or making goods (raw material and inventory), charging for depreciation.

Positive cash flow means company has more cash in end than beginning, negative means the reverse.

Cash comes to business either from operations (payment from customers etc) or financing (borrowing money, selling shares).

Cash goes out of the business when you spend for operations (buying raw material), financing (pay back loan, pay dividend), capital investments (buy shares, dividends, productive assets), paying income tax.

Cash from operations is the cash generated from day to day activities. This is a good measure of how well the enterprise is management operations.

However it’s just a element of cash flow.

Cash flow from investing activities is buying fixed assets, lending, investing. This indicates the usage of money generated from operations. If you take out fixed asset spend we call that as free cash flow which belongs to shareholders.

Now if you can not invest from operations you need to finance it somehow. That is called cash flow from financing activities like selling bonds, shares, paying back the loan taken earlier for financing, dividend payment. A company with negative free cash flow paying dividend is actually borrowing and paying you. Can be very dangerous.

Connecting Balance Sheet (BS), Profit & Loss (PL) and Cash Flow (CF)

The beauty of financials statements is New Delhi☺, snow fall in Shimla, Delhi becomes cold. Loo in Rajasthan, Delhi suffers. All financial statement items are connected to each other.

Let us understand these connections:

Just keep two things on mind: The flow of cash and flow of goods, services.

Remember the basic equation of accounting which is total assets is equal to total liabilities. So when you subtract anything from asset you need to either add into another asset or subtract from liability.

Net income (PL) is added to retained earnings in BS.

When sales is made on credit net sales is shown in PL, collectible amount becomes trade receivables on BS.

When sale is made product is moved from INVENTORY (BS) to Cost of goods sold in PL.

When a customer pays off money trade receivables reduced and in turn cash receipts increase the cash balance.

When a sale is entered in PL, net income is generated and added to retained earnings (general reserve) to BS.

Expenses when incurred and added to PL becomes trade payable on BS.

Expensed when paid reduces trade payables and reduce cash balance (both within BS).

There are lot more dots, suggest you start connecting and ask questions if any. Al lot of these we will cover during analysis of an investment.

The last piece for now, lets get into how did financials constructed:

Journals and ledgers: every event having a financial impact is known as financial accounting. Accounting summarize and track these events through journals and ledgers otherwise called “books”.

Ratio analysis: the relationship between the accounting number are established with the help of ratios. For example net profit to net sales tell us what is the ultimate margin we are getting. When we plot it over several years it tells us how we are doing, or check with competitors to know are we better off.

Common size statements: if we split PL to a common base i.e. say sale 100, cost of goods sold becomes 65, operating expenses 10, other expenses 10, net profit becomes 15. All in percentage, we can compare this year to year, this will give us a edge avoiding absolute number which can be distorted by a base effect. E.g. 100 to 120 is 20% rise, 1lac to 1.02 lac is 2%, if we read absolute number we may get carried away between 2 lac and 20. However both situations can be dangerous, we need to put our thinking hat on and on.

Not to worry, what type of common size statements or ratios are required…we have loads of time to analyze.

Thanks again for reading me out, I will touch base on investment philosophy next. Meanwhile you can go through financials and it’s good and bad to understands in detail from several sources available on net.

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