Understanding Financial Report – Part II

Hi all, it’s been a while since my last post about personal finance. This is the second part of understanding financial report which called Profit-Loss report (P/L), you can check the first post about understanding Balance Sheet, here. This is the most interesting part for me since we can imagine the numbers by using simple examples. In addition, there are many major information related with how well a company operates at a glance only by using this report. Let’s go check it out!

Revenue

As the name suggest, this part shows how much money the company make during a period, either in a quarter or in one year. A simple example of this is imagine you sold a cup of caramel macchiato to your friend for IDR 100K. This amount is what we call a revenue, in normal condition. We want to find companies with good revenue growth, ideally year on year since quarterly report can be affected by many factors. For example, Lebaran is a big holiday in Indonesia but the date will change every year, so many consumer companies get a bump of revenue right before that festive period. It’s different with mining industries where their performance also relates with global commodity price like oil or copper. The growth in revenue is also relative, usually companies with large market capitalization will not grow as much since they are already mature, provide more stability and less risk for the stakeholders. On the other hand, medium to small companies can have higher revenue growth since they are more agile, especially if their business is something many people needs in the future. However, they also possess higher risk factor.

Cost of Goods Sold (COGS)

After we get the revenue from the coffee we sold, we need to remember that we don’t grow the coffee plant by ourselves in most cases. Mostly we will buy the coffee bean from our suppliers. This also applies to any ingredients we use to make that cup of coffee like sugar, milk and packaging. These ingredients are part of Cost of Goods Sold in the report and we need to substract our Revenue by its COGS. Ideally, we should aim for positive value here by either finding ways to increase Revenue – by increasing the price, for example – or reducing the COGS, like find better deals with the suppliers. Good companies tend to have decreasing or stable COGS in their report. By stable here means although the COGS increased, the Revenue part grows higher.

Gross Income and Gross Margin

The amount left after we substract Revenue with COGS is what we call Gross Income. The division between Gross Income with Revenue is the Gross Margin or the Gross Profit Margin (GPM). For the example above, if we get IDR 100K for every cup we sold and we pay IDR 30K to the suppliers (coffee, milk, sugar, packaging), then we end up having IDR 70K as our Gross Income, or 70% Gross Profit Margin. Again, we want to find companies with an improvement or stable Gross Margin year on year.

Operating Cost and Operating Margin

When we have a coffee shop, it’s very unlikely that we do everything by ourselves. We will hire some people to help us run the shop, we will also do some promotion to attract more customers, and with the digital era, we will also spend some money into ads to grow our brand further. These are the examples of operating cost which the companies also need to pay. From the IDR 70K we have after paying the suppliers, imagine if we need to pay our employees by IDR 20K, short term promotion for another IDR 10K, and lastly spend some budget in ads for IDR 20K, totaling IDR 50K. This amount is the operating cost and the business will end up having IDR 20K. The Operating Margin in this case is 20% since every margin calculation will have Revenue as its denominator.

Net Profit and Net Profit Margin

Up until this point, you may wonder is there any more cost after we only have IDR 20K left? Unfortunately, the answer is yes. Business still needs to pay taxes to the government. However, tax for business is totally different story with the tax rules for employee. Government can give tax breaks to stimulate more company growth. This means the companies can keep the full IDR 20K for certain period. Another stimulus is tax discount, which usually will provide advantage for certain companies who support government initiatives like affordable housing, renewable energy or large infrastructure projects. From our example, imagine that we got 10% tax, meaning we will end up with IDR 18K after tax. This is the bottom-line number called Net Profit and the Net Profit Margin (NPM) in this case will be 18%. Ideally we will want to find companies with stable or growing Net Profit Margin.

Closing

Hope this short post can help you understand how Profit and Loss Report is made and find companies with good operating model. Be careful when company reports unusual increase in Revenue or any margin calculation from the above sections. Chances are, it’s only one time shot and can’t be repeated in the next reporting cycle. For the next part, I will share the third part of Financial Report called Cashflow. See you in my next post!