In this lesson, you’re expected to learn about:
– judging the quality of profits
– calculating how well your investments are paying off
Not all profits are created equally; sometimes a source of profit is volatile, temporary or uncertain, which can result in poor-quality profits. In contrast, quality profits could be where a company rents out properties and are receiving a continuing profit through these rentals, so the profit they receive is stable and continuous.
As we describe in this lesson, two primary aspects can undermine the quality of the profit listed in the financial statement: the use of different accounting methods and the sources of revenues and costs.
You can then break down each of these groups into more detailed concerns, with each influencing whether the profits a company is generating are sustainable, maintainable or retainable.
Just because a company seems to be profitable doesn’t mean that the business itself is successful or even that it isn’t at risk of going out of business.
Tackling Accounting Concerns
Despite the reputation of accounting as a field of stiff regulations and methodologies, in fact companies are given freedom to decide their preferred method of valuation on several issues.
Sometimes they’re allowed to decide the accounting period to use for a particular cost or revenue (within the parameters of Generally Accepted Accounting Practice); other times they can choose from several options the manner in which they value their costs, revenues or assets.
Naturally, with companies recording these things using differing methods, variances occur, and as a result the exact manner in which you view or interpret the financial statements also changes.
For example, a company may appear to have unusually high profits one year, until you realize that it deferred certain costs until the next year in order to better use its tax deductions; otherwise, it would’ve lost money in the current year (even though, of course, this goes against the ‘matching’ principle in which costs should be matched against their respective revenues).
With financial statements, things aren’t always as they seem. Your ability to understand the implications of the accounting decisions that companies make can be just as critical as your ability to calculate the financial ratios themselves.
Here are some of the more common accounting issues to bear in mind.
Three primary methods of stock accounting exist:
1) FIFO: Stands for first-in, first-out, which means that whatever stock was produced first is considered to be the first stock sold. When measuring the cost of sales, the company measures the cost of producing the first items made rather than the most recent items made.
2) LIFO: Stands for last-in, first-out, which means that the last items to become stock are considered the first to be sold. So when measuring the cost of sales, the company measures the cost of producing the most recent stock made rather than the first stock made.
3) AVCO: Stands for weighted average cost. Using the AVCO method, you calculate the weighted average cost of items held at the beginning of the year with the following formula:
Weighted average cost = Total cost of goods in stock / Number of items in stock
The weighted average cost is then used to value goods sold. You need to calculate a new weighted average cost, however, each time more stocks are bought during the year.
Using the FIFO method, on the other hand, gives the illusion of costs being lower than they really are, because the company is accounting for the cheaper historical cost of production.
Neither one of these methods is inherently bad, but you do have to take these aspects into account when studying the costs, liabilities and profits that a company generates.
Note: Be sure to understand that just because a company appears to be ‘safe’ right now doesn’t mean that this situation can’t be artificially generated.
The method of depreciation a company chooses has an influence on the P&L account (because depreciation is included as a cost) and the balance sheet (because depreciation influences the total value of the company’s fixed assets).
Therefore, knowing what type of depreciation the company uses helps you to understand how to interpret financial statements and their respective ratios. Particularly for organizations with a large amount of fixed assets with depreciation to account for, the chosen method of accounting can have a significant impact on how those companies’ profits look to analysts who don’t consider this fact.
Although many potential sources of low-quality cash flows exist, we cover just two of the most common: temporary transactions and volatile income sources.
The problem is that these things aren’t necessarily listed as separate items in the financial statements (though they often are).
If you’re a shareholder, you have the right to request information regarding those items listed in the ‘other’ categories. Doing so may also be a good idea if you’re considering investing in such a company.
Be on the lookout for the cash flow statement, because that helps you identify where all the money is coming from and where it’s going, though often only one year at a time.
To identify these issues, you often have to resort to evaluating the company’s quarterly reports (financial reports that are issued every three months). These reports can help you identify something that’s going on within a single year that may not be easily identified in the annual reports.
This aspect is usually determined by whether or not the spent money creates a positive return on investment. If you spend money on something, you hope that it contributes to the creation of revenues greater than the amount spent; otherwise, that particular purchase is contributing to your company losing money.
However, determining whether a company is successfully using its money to invest in assets and operations isn’t always easy.
Let’s explore some useful methods.
Assessing the value and price of an investment
Your ability to compare the actual returns against the projected returns is a huge part of your ability to establish what success is and whether you’ve been successful in your investments.
You can measure the degree of failure or success in these cases simply as the percentage over or under the projected rate of return. If you’re expecting 10% returns and you get 20% returns, you’ve succeeded by a margin of 200%, which may result in a big, end-of-year bonus!
The arithmetic rate of return on a specific asset is a spot measurement that measures only the total rate of return over the life of the investment, as shown below:
information about how well you’re using your purchases, assets, investments etc.
For those assets that don’t increase in value but produce things of value (such as machinery), you can include the value produced as a part of your value at time, t.
You add up the rate of return from each year, and then divide it by the number of years you’re measuring to get the average rate of returns.
1. Find the arithmetic rate of returns from each year and add 1 to each.
2. Multiply the answers together.
3. Divide your answer from Step 2 by 1/n, where n is the number of years.
4. Subtract 1 from the value in Step 3.
5. Multiply the value from Step 4 by 100 to get your answer as a percentage.
RAROC = Rate of return + Economic capital
Economic capital is the amount of liquid assets that a company needs to keep on hand so that it can handle risk concerns: credit risk, liquidity risk and so on. Therefore, the RAROC method of calculating the rate of returns accounts for risk generated by measuring the amount or return per unit of capital the company must keep on hand to compensate for the additional risk generated. This is a measure that is used by banks in particular.
Another concept that you can use with any expenditure or investment is generally applied to evaluations of the success of investment portfolio managers. These evaluations involve the actual returns, risk and average market returns.
As with evaluating the estimated price and value of assets compared to the market, the degree of success is also evaluated in such a manner.
This equation may look familiar, because it’s almost identical to the CAPM equation we saw last week — with just one key difference: you start with the actual returns on an investment and then subtract the value of the investment as calculated by the CAPM model.
Hedge fund and other portfolio managers are often evaluated on their ability to generate a consistently high alpha value on a given portfolio, or some variation of alpha.
Here’s how you calculate the ratio:
Measuring performance this way incentivizes portfolio managers to take risk but ensures that they’re generating greater returns for the portfolio than volatility.
You calculate the Sterling ratio in the following way:
As a result, this calculation rewards risk of lost value but only if the returns on investment are higher than the risk incurred.