Welcome back to our back-to-basics Craft of Rule Maker series. We're on our way through the financial criteria that form the bedrock of Rule Maker investing.

Yesterday, we presented an overview of financial statements and how to actually find a company's all-important financial data. Today, we'll begin our walk through the income statement by taking a look at the key driver to any company's growth -- sales. (Note: I'll be using the terms "sales" and "revenues" interchangeably throughout this report.) When we talk about expanding possibilities, what we're really looking for is the potential for sales growth. Continuously expanding sales are essential to the long-term increase in value of a Rule Maker's shares.

Over the last 10 years, it's hard to find a company that's been able to grow sales more consistently than Cisco Systems (Nasdaq: CSCO). When Cisco went public in 1990 it had revenues of $69 million. In its fiscal year ended this past July, Cisco's sales were $18.9 billion. That means that in the course of each business day in fiscal 2000, Cisco was able to generate revenues equal to the total of that collected in its first full year as a public company! That also equates to annualized sales growth in excess of 75% over a 10-year period. That's simply an incredible performance -- as can be attested to by the portfolio of any long-term Cisco shareholder.

Now, we're not expecting every Rule Maker to grow at such a torrid pace. All that we're looking for when evaluating Rule Makers is annual sales growth of at least 10%. Growth at this level assures us that the company can sell more of its stuff year after year, indicating either rising customer demand or pricing power -- or some combination of the two. Absent these two ingredients to sales growth, you get stock performance along the lines of Coca-Cola (NYSE: KO).

In recent years, Coke ran out of room to raise prices and demand for cola has stagnated. Consequently, sales at Big Red have grown only 4% annually for the past five years. The result has been a stock price that's risen only about 7% annually over that time span.

So, let's pull out our calculators and take a quick look at how we calculate sales growth:

Sales Growth = (Current Sales / Year-ago Sales) - 1

In other words, all we have to do is divide the most recent sales amount by that for the year-ago period and subtract 1. Here are the numbers needed to calculate sales growth for Cisco's most recent quarter (Q2 2001):

                  Q2 2001              Q2 2000
Net Sales     $6.748 billion       $4.357 billion

The result: Cisco increased its sales by 55%. The calculation is: (6.748 / 4.357) -1 = 0.55, or 55%. That's just an amazing result. Few companies the size of Cisco are growing sales at 10% per year -- let alone more than 50% a year. Cisco's networking wares are clearly in enormous demand.

Cisco has been able to record this type of revenue growth by continuously expanding its product lines into new areas both by internal development and acquisition. In the beginning, Cisco's line of network infrastructure products consisted only of routers. It now offers its customers complete end-to-end networking solutions, which separates Cisco from competitors such as Juniper Networks (Nasdaq: JNPR) that focus on only a single product family.

During its history Cisco's management team has been able to foresee the expanding possibilities in its industry and has been able to capitalize on these opportunities again and again. Of course, as we learned in Cisco's most recent earnings release, the company is now expecting that its rate of sales growth will fall to about 40% in the near future.

Let's take a look at why sales are so important. If you take a look at Cisco's income statement in the earnings release linked above, you'll see that the first line is "net sales," which is the same thing as revenues. Cisco uses these revenues to grow and expand the business in a variety of ways:

  • Cover the cost of producing its networking products and related services;
  • Market its business through advertising, promotion, and customer education events;
  • Invest in new product lines via research and development;
  • Invest in new processes or equipment that improve the efficiency of its operations; and
  • Generate enough cash to cover any other costs or expenses that may incur (i.e., the office holiday bash).

As you can see, revenues are the lifeblood of a company. But wait, you say, isn't cash the lifeblood of a company? (Great question, Fool.) Yes, one thing you should be aware of is that revenue doesn't always represent the actual receipt of cash. This brings us to the sometimes-ugly topic of revenue recognition. As an investor, you should be aware that revenue is often the subject of abuse and manipulation.

The problem is that companies don't record revenues and expenses on the basis of cash receipts. Instead, they use the accrual method of accounting for transactions required under Generally Accepted Accounting Principles (GAAP). The result is that revenues can be misstated. As a matter of fact, statistics show that more than half of all financial fraud cases brought by the SEC last year were based on improper revenue recognition.

And it's not just small companies that have had problems with either fraudulent or aggressive revenue recognition practices. Our special "Lucent at Bat" tells the now-infamous case of how Lucent (NYSE: LU) recklessly financed its customers purchase of Lucent equipment. When these problems arise, expect to see the company's stock price go down the tubes. Some other companies that have had revenue recognition problems are MicroStrategy (Nasdaq: MSTR), Cendant (NYSE: CD), and Oxford Health (Nasdaq: OXHP).

But I'm getting ahead of myself. Next Thursday, in Part 7 of this series, I'll explain the Foolish Flow Ratio and a few other related ways of making sure a company is recognizing revenue appropriately. Tomorrow, we'll continue with the second Rule Maker income statement metric to befriend: gross margin. And finally, please don't forget to sign up for our upcoming 2001 Rule Maker online seminar, The Art of Rule Maker ($49), in which we'll unpack the qualitative side of Rule Maker analysis.

On a personal note, in my last column I told you that we had lost our 14-year-old Shih Tzu, Amelia, to cancer. I want to take this opportunity to thank each of you that responded to our loss via personal email or discussion board post. Your thoughts and sympathies have been greatly appreciated. Without Amelia our home has been quieter than usual, and we've all been feeling a bit down (particularly our other Shih Tzu, Brandy). On Monday night we decided that one of the best ways to honor Amelia was to add a new furry friend to our household. So, we brought home Carly, who we first met by chance on my birthday this past Saturday. Amelia will live in our hearts forever, and we think we've honored her memory yet again by bringing Carly into our hearts and home.

Part 4: A Grossly Profitable Business �

Phil Weiss and his family reside in northwestern New Jersey. At the time of publication he owned shares of Cisco, but he didn't own shares of any of the other companies mentioned in tonight's column, as he doesn't invest in companies that have accounting problems. If one arises, he'll sell first and ask questions later. You can see his other holdings on his profile page. The Motley Fool is investors writing for investors.