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Part 4: The skill you didn’t know you needed: Building a basic financial model

Published 03 May 2022

In March we explained the nuances, and spruiked the excitement that can be found in a company’s annual report. This month we find ourselves in a similar situation, this time via a company’s income statement and balance sheet, to the building blocks you need to construct a financial model.

Again, this process might not seem glamorous, but being able to read and interpret financial statements is an essential part of investing. As Warren Buffett said, “Accounting is the language of business.” The man is a magnate for a reason.
When you can interpret a business’s financial statements, amazing things happen. You can extrapolate a company’s future earnings and cash flows, which then leads you to estimate the fair value of a business by discounting these future cash flows back to the present.

This process, formally known as a Discounted Cash Flow (DCF) model, is critical to Holon’s investment process, and this is how our investment team assesses whether a company is undervalued relative to its stock price. Incorporating a financial model/DCF model is not an exact science because, as we all know, the future is unpredictable. However, its application is helpful when estimating a company’s fair or intrinsic value. In these times of extreme stock price volatility this is especially important as temporary stock mispricing allows you to buy high quality businesses below their intrinsic value.

Income statement

The company’s income statement is the backbone of any DCF model. How much a company grows over the long term depends on how much revenue the business generates, and the total costs needed to fund its business operations.
Let us walk through the core components of a company’s income statement, depicted in the figure below.

1. Revenue
Also known as sales, is the first line item shown on a company’s income statement. A company’s revenue refers to the income a company generates from its core business activities before costs, taxes, and other expenses are deducted. One of the first things an investor should look for in an investment is whether the company is consistently growing its revenue over time.

2. Cost of Revenue (Cost of Goods Sold, or COGS)
A company’s cost of revenue refers to the expenses that are directly spent producing, distributing, and manufacturing the goods or services a business delivers to its customers.

3. Gross Profit = Revenue – Cost of Revenue
By subtracting a company’s cost of revenue from its sales, we get gross profit. A company’s gross profit margin (gross profit divided by revenue) is a useful metric which details how efficiently a company generates profit directly from the sale of its goods or services. Additionally, gross profit margin can be helpful to compare the performance of a company against its direct competitors.

4. Operating Expenses
Operating expenses (OPEX) are another cost businesses incur to do business (rent, insurance, utility bills, etc.) But unlike the cost of sales, operating expenses tend to include a greater percentage of fixed costs deemed essential to run the business. These expenses remain relatively constant, meaning they are not directly impacted by fluctuations in revenue.

5. Operating Profit = Gross Profit – Operating Expenses
A business’s operating profit is the net earnings generated from its core operations after COGS and operating expenses are deducted from its revenue. A company’s operating margin (operating profit divided by revenue) is a good measure of how efficiently management is operating the business. We look to invest in companies with high or growing operating margins because these businesses typically have some form of competitive advantage.

6. Net Interest Expenses (Non-Operating Expenses)
Net interest expenses refer to the total interest paid by a business on any outstanding debt, net of any interest income received from investments outside of the company’s core operating activities. Put simply, high interest expenses imply a high amount of debt. Many investors tend to avoid companies that have high interest expenses relative to their revenue, as a company may struggle to pay these expenses as they come due if its earnings were to fall unexpectedly.

7. Income Before Income Taxes = Operating Profit – Net Interest Expenses.
Income before taxes, also known as ‘taxable income’, is a company’s net income after deductible operating and non-operating expenses. This figure is used to calculate the taxes a company pays out.

8. Income Taxes = Taxable Income x Income Tax Rate
Corporate income taxes are the taxes a business pays on its taxable income generated through their business activities. Income taxes are charged as a percentage of a company’s taxable income and vary depending on the firm’s domiciled country. For example, the corporate tax rate for US businesses is currently set at 21% of a business’s taxable income.

9. Net Income = Taxable Income – Income Taxes
Finally, the last line item on a company’s income statement is net income – the income a company receives once all business costs and other expenses are deducted. This value is used to calculate a company’s earnings per share (EPS), a helpful metric that divides net income by the total number of outstanding shares.

Balance Sheet

As we touched on last month, a company’s balance sheet is the financial statement that represents a snapshot of its assets, liabilities and shareholder equity at a particular point in time. Within a financial model, the term ‘balance sheet ‘is used as the business’s assets must equal its liabilities plus shareholders’ equity. This is what is known as the accounting equation, as detailed below.

Assets = Liabilities + Shareholder Equity

This accounting equation can also be rearranged to find the reported ‘book’ value of a company’s shareholder equity.

Shareholder Equity = Assets – Liabilities

Understanding a company’s balance sheet is critically important as it portrays a business’s financial health – i.e., how solvent and financially stable it is. Below, you’ll find an example of a typical balance sheet, which we will walk through step by step as you form your own financial model.

Current Assets

A company’s current assets are the most liquid holdings a company owns and are defined as assets that can be converted into cash within 12 months. A company’s current assets typically include cash, short-term investments, inventory and accounts receivable. Having an adequate cash balance is important as a precautionary buffer against unexpected expenses and business shocks. However, as cash generates a very small return (especially in today’s low interest rate environment) holding large amounts of cash may be an ineffective use of a company’s capital, which could otherwise be used to invest in new projects with higher returns on investment.

Non-Current Assets

Non-current assets are a company’s long-term assets, which typically cannot be converted into cash quickly. Non-current assets can be tangible, such as property and equipment, or intangible, such as intellectual property. Many of the technology companies Holon invests in are less capital intensive than traditional bricks and mortar businesses such as supermarkets or infrastructure companies. ‘Capital light’ businesses such as Xero or Coinbase, tend to have fewer tangible assets and higher intangible assets on their balance sheets.

Current Liabilities

A business’s current liabilities are the short-term debt and other obligations owed by a company that are due within a year. Included in this is accrued expenses and accounts payable. Typically, a company meets its current liabilities obligations with its current assets.

Non-Current Liabilities

Non-current liabilities are a company’s long-term debts and obligations that become due after 12 months and include long-term loans, bonds payable, lease obligations and deferred revenue (subscription-based products or services that require prepayments). Generally, mature companies with more stable cash flows tend to support a greater proportion of long-term liabilities on their balance sheet.

Equity

The final component of a company’s balance sheet is the statement of shareholders’ equity, which refers to the net value of a company’s assets attributable to its shareholders after all its liabilities are paid off. Paid-in capital or contributed capital refers to the cash paid or contributed by investors in exchange for a company’s stock (equity). Moreover, retained earnings refer to the earnings a company accumulates, which are not paid out to shareholders in the form of dividends and share buy backs but instead are withheld and utilized to continue growing the business.

Next month we’ll unpack the cash flow statement and bring all three statements together to develop a basic discounted cash flow model.

Another quote we love from Mr Buffett:

“The important thing is to know what you know and know what you don’t know.”

With this rundown of a company’s income statement and balance sheet, hopefully you now know more of what you didn’t know before.

 

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