As practitioners of the long-term buy-and-hold approach to investing, we here in the Rule Maker portfolio are not especially concerned about the day-to-day fluctuations of the stock market. Our focus is more on understanding the businesses of our companies. One way that we further our knowledge is by reviewing and understanding their financial statements.
Tonight, I'm going to revisit two of the line items you can find on an income statement -- the two that get the most questions on our Rule Maker message boards (linked below). I'm also going to discuss how these items are tied to the balance sheet. (Those that are interested in a top-to-bottom income statement analysis might also want to read this column.) Along the way, I'll try to bring this conceptual accounting stuff down to earth by using plenty of company-specific examples.
The first line item you'll find on almost any income statement is sales, or alternatively, revenues. This figure represents what the company's customers pay for its products or services.
However, that doesn't mean that the sales number you see on an income statement is a final figure. Generally, product revenues are recognized when the product is shipped, and service revenues are recognized when the services are performed. This means that if a customer returns a product, or if a customer fails to pay for a product, you'll find that the sales figure has to be adjusted. As a matter of fact, when you read about a company that's been accused of accounting irregularities, it's not uncommon to learn that the accused company has overstated its sales by doing something like flooding the sales channel with product. This was a problem for Sunbeam (NYSE: SOC) during the latter days of the reign of "Chainsaw" Al Dunlap.
There are a number of ways you can use the balance sheet as a sanity check for the sales figure on the income statement. The simplest is to compare the growth in accounts receivable to the growth in sales. If accounts receivable are increasing faster than sales, that may indicate a problem.
The way that I usually like to check the sales figure is to look at days sales outstanding (DSO). On a quarterly basis you can calculate this figure by taking (Accounts receivable/(Sales/90)). DSO tells you how long it takes a company to collect sales revenue from its customers. I also like to compare a company's DSO figure to those of its competitors. This gives me an idea as to how much importance a company is placing on minimizing the interest-free loans that it extends to its customers. Collecting these outstanding debts quickly will also help to keep the flow ratio low.
Some companies even defer some of their revenues. When this is the case, you'll find the "deferred revenues" figure in the liability section of the balance sheet. The reason this is a liability is that a customer has paid for something (usually a service) that the company hasn't yet performed. As a general rule, deferred revenue is one of the liabilities that I like to see on a balance sheet. A company is operating from a position of strength when it receives payment prior to actually rendering the product or service. Among the companies that I've found with deferred revenues are Microsoft (Nasdaq: MSFT) and America Online (NYSE: AOL).
But not all deferred revenues are created equal. I recently came across a company for which I viewed deferred revenue as not being very meaningful. The company was X-ray device maker Hologic (Nasdaq: HOLX). In the Revenue Recognition section of the company's financial statement footnotes, it said the following: "The Company has reserved for potential losses under these contracts by deferring revenue of an amount equal to 10% of the contracts funded." While on the surface this seems to be conservative accounting, it's certainly not deferred revenue that you can count on to make its way to the income statement in the future like you can with Microsoft or AOL.
There are also companies that immediately book revenue even though it hasn't yet been billed to customers. This is most common in cases where revenue is realized from long-term contracts. This revenue represents noncash revenue and can also be found on the balance sheet in the form of either deferred or accrued revenue. As in the case of Hologic, there are no guarantees that such revenue will ever be earned in the future.
If you're not sure about what a company's revenue recognition policy is, the best place to look is the financial statement footnote that's usually called "Summary of Significant Accounting Policies."
The other section of the income statement that's particularly important to Rule Maker investors is cost of sales (for manufacturers) or cost of revenues (for service providers). Cost of sales represents the costs incurred in purchasing raw materials and converting those raw materials into finished goods. Cost of sales does not include research and development (R&D) expenses or selling, general, and administrative (SG&A) costs.
There can be some differences from company to company in how cost of sales is calculated. For example, some retailers -- such as Gap (NYSE: GPS) -- include occupancy costs related to their retail locations, while others -- such as Ann Taylor (NYSE: ANN) -- do not. A review of the accounting policy section or the footnotes to the financials will give you a better handle on how a particular company treats such costs.
Cost of sales also includes depreciation expenses that relate to the plants in which goods are manufactured. Manufactured products show up on the balance sheet as inventory. Normally inventory is broken down into three categories: raw materials, work-in-process, and finished goods. Of these, the one that I least like to see is finished goods. This is because finished goods are those that are ready for sale to customers but have not yet been sold. I'd rather see customers scooping up all of the available finished goods than see them sitting on some shelf waiting to be sold. This is especially true for tech companies, like Intel (Nasdaq: INTC), who sell products that can quickly become obsolete due to technological innovation.
Sometimes, nonmanufacturing companies don't report cost of revenues on their income statement. Disney (NYSE: DIS) is an example. In such cases, it's up to the investor to try and identify the items that make up cost of revenues. This determination should be made based upon your understanding of the company and its business. You should try and identify only those costs that are incurred in providing the service. Those that are incurred in selling, marketing, or developing the service are not part of cost of revenues. In the case of Disney, the company lumps all of its costs into one line item, "costs and expense," thereby making it impossible to calculate a gross margin, which happens to be our next and final topic.
Revenues (sales) and cost of revenues (cost of sales) are used to determine a company's gross margin. The higher the gross margin, the better. Gross margin tells us how much profit remains after input costs (cost of sales) are subtracted from each $1 of sales. For Microsoft, the input costs for selling its software amount to less than 15 cents for each $1 of sales. Bill Gates' company has a gross margin of 85.7%, which means that 85.7 cents of each dollar of sales is left to market its software and e-commerce services. High gross margins allow a significant portion of sales to be reinvested in the business, while still allowing a significant portion of revenues to ultimately flow to the bottom line in the form of net income.
I hope that you've found this expanded discussion of sales and cost of sales to be helpful. If you have more questions about what I've covered in tonight's report, please feel free to ask on our message boards.
Finally, this morning, we executed our purchase of five additional Microsoft shares at a price of 93 5/16. Including our $7.95 commission, our transaction total was $474.51. You can follow our monthly purchases at our trade history page.
Phil Weiss, Fool