Decoding Income Statement

I remember this conversation with a friend (who happens to be a graphic designer). The guy had recently finished reading the book “The Psychology of Money by Morgan Housel”. He was super pumped about his DIY investing journey. On asking what company he got into, he reveals his first ever stock purchase was V-mart Retail Ltd. I further asked him about his rationale and why he chose the particular company. He tells me he has a store nearby his house and that he sees decent footfall; the company sells high-margin products compared to its peers and has a history of growing revenues. Not to take a dig at my very real and non-imaginary friend here, but this talk about growing revenues got me thinking…

 Is revenue the same as cash?

It has come to my attention that laymen may have a wrong understanding of the term revenue. This a misconception, perhaps, because it is always cited in the news articles and also most talked about when communicating how well a company performed during the quarter or the year-end. It is the very first line in the Income statement. Revenue refers to the amount of money generated by conducting routine business operations, which is determined by multiplying the average sales price by the number of units sold. (Not necessarily in cash)

Breakdown of Revenue

From the revenue, we subtract the costs involved in making the sales, an entry called cost of goods sold, and this gives us the gross profit. Gross profit is nothing but the profit the company makes after accounting for the costs to produce the sale.

The journey from gross profit to operating profit involves subtracting all the operating costs from the gross profit. This includes the employee's salary accounts, raw materials cost, electricity expense, manufacturing costs, administrative head, depreciation & amortisation and so on. Doing this lands us to Operating profit (EBIT). The operating profit is the money that the business makes before meeting the interest obligations and accounting for the tax. A common practice when comparing companies with different asset sizes, is adding back the depreciation and amortisation to the operating profit and comparing them on EBITDA levels. 

EBITDA is a Non-GAAP measure used when the comparables have made investments in the physical or intellectual property of significant difference and, as a result, incur different yearly depreciation or amortisation costs. These expenses lower net income as well as EBIT.

The Relationship between Income Statement and Cash Flow Statement

The net income amount that appears on the income statement differs from the cash the company received during that year and what we think the company actually generated during that year. It could be more or less. Additionally, without cash, the figures on the income statement are just as fictitious as the cherry on a subpar pastry. Anytime high earnings are claimed, they should be verified and backed up with real money, cash. The relationship between the Income Statement and the Cash Flow Statement must therefore be understood.

The relationship between the EBITDA, Net Income, and CFO for D-Mart, one of the most efficient and profitable hypermarket retail businesses, is depicted in the above image. Why should we examine these linkages and graphs? Because accruals are a way of life for us, and depending on how it is used, credit has the ability to either make or break a business. Furthermore, by examining these relationships, we are searching for unfavourable accruals. By doing this, we should be able to see any frauds or anomalies in the accounts, as money is harder to fabricate or manipulate than accounts, which can be twisted and misrepresented.

All that we check is that EBITDA, Net Income, and CFO have a steady relationship. The Net Income and EBITDA have been steady over the past few years, as seen in the graph above. Although there is no way to predict the future, we can reasonably assume that Net income and EBITDA statistics in the near future will remain stable relative to one another. We can also observe that the CFO is not bouncing around the Net income erratically. This demonstrates that the CFO for D-Mart is generally steady, and we don't anticipate many variations from the Net income. The reason is that, in comparison to other industries, D-Mart doesn't function in a space with huge receivables or payables. And as an investor, I feel secure knowing that the company is earning money without making too many accruals and that the company has the capacity to provide consistent cash flow from its ongoing commercial operations.

The graph above shows the same relationship for V-Mart Retail Ltd, another hypermarket setup, which falls in line with the peer group for D-Mart. If we look at the Net income and the EBITDA, they seem fairly stable and in line with each other, at least till year 2019. Right after that, you can see how drastically the relationship deteriorated or, if you will, lost its charm.

The CFO in the year 2021 took a huge detour nearing a negative territory in the most recent year. This may also reveal any fudging or a high number of bad debts, if any, which is not good for the future prospects of the company and its investor. This is when you, as an investor, start appreciating what a company like D-Mart has to offer. I, as an investor, wouldn't feel comfortable or safe with a business painting the above picture. Give me cash, not just revenues, but also make it come from the business and not by selling assets.

What do CFO, Net Income and Revenue mean for Investors?

One great way to gauge the quality of earnings of a business is to use CFO/NI. The quality of earnings ratio is another name for this ratio. It is calculated by dividing the CFO by the company's net income. If CFO is higher than the net income, it is assumed that the company can transform its accrued earnings into cash. Otherwise, the company uses inadequate cash flow management techniques.

The Bottom Line

What are the main reasons why net earnings and cash flow from operations differ from one another?

Because there is a lag between reported sales and actual payments, cash flow and net income statements are typically different. If consumers who have been invoiced pay in cash during the following period, the situation is under control. If not, then you may see a huge number in revenues and net earnings but no cash to actually back it.

I hope next time you hear about a company reporting high earnings, you ask the question, "How much of it actually translates to cash?"