Chapter 02 · Reading a company's numbers
Revenue, cost, and what is left
Revenue is not profit, and profit is not cash you can take home. This chapter walks from the top line to what is left for the owner, and shows how a small change in cost can matter more than a large change in sales.
Follow one rupee of sales
Take a simplified manufacturer. In a year it records ₹1,000 crore of revenue. Materials and factory wages that vary with output cost ₹620 crore. What remains, ₹380 crore, has to pay the costs that do not move as quickly: salaried staff, rent, insurance, depreciation of the plant. Suppose those are ₹210 crore. Operating profit is ₹170 crore. Interest is ₹30 crore. Tax at a rate you will look up for the actual company, not invent here, takes a further slice. What remains is the profit attributable to shareholders.
The useful habit is to write the margins, not only the rupees. Gross margin here is 38%. Operating margin is 17%. If next year revenue grows to ₹1,100 crore and the variable costs stay at 62%, gross profit becomes ₹418 crore. If the fixed costs stay ₹210 crore, operating profit becomes ₹208 crore. Revenue rose 10%. Operating profit rose about 22%. That gap is operating leverage. It works in reverse just as fast. A 10% fall in revenue, with the same costs, cuts operating profit by much more than 10%, because the rent does not fall with the orders.
Costs that hide
Depreciation is a real cost of using up a machine, even though no cheque goes out this year. Ignoring it makes a capital-heavy business look richer than it is. Stock-option expense is pay, even though it is paid in dilution rather than cash. A loss on a foreign-currency loan is a cost of having borrowed in another currency. ‘Adjusted’ profit that adds all of these back needs a reason for each addition. Some adjustments remove a genuine one-time event. Some remove the ordinary cost of being in that business.
Other income deserves its own line in your notes. Treasury gains, a dividend from a subsidiary, or a profit on selling land can be perfectly real and still say nothing about next year’s sales. Keep operating profit and total profit apart in your head. Celebrate the second only after you know how much of it was the first.
A worked fall, so leverage is not only a happy story
| Base year | Sales up 10% | Sales down 10% | |
|---|---|---|---|
| Revenue | 1,000 | 1,100 | 900 |
| Variable costs at 62% | 620 | 682 | 558 |
| Fixed costs | 210 | 210 | 210 |
| Operating profit | 170 | 208 | 132 |
| Change in operating profit | — | +22% | −22% |
The percentages are the lesson. A business with high fixed costs will look wonderful in a boom and fragile in a slowdown, even if the managers did nothing differently. Before you pay a high multiple for fast recent growth, ask which costs would remain if the growth paused for a year.
What is left for you
Shareholders’ profit divided by the number of shares is earnings per share. That is the slice, not the company’s pride. If the company earned ₹132 crore and has 20 crore shares, earnings are ₹6.60 a share. If it then issues 4 crore shares to buy a rival, the next year’s profit has to rise just to stand still on a per-share basis. Always carry the share count in the same note as the profit.
Dividends are what the board actually sends you. Retained earnings are what it keeps, supposedly to make next year’s profit larger. Neither is free. A dividend you receive is cash the company no longer has. Retained earnings you never see can be wasted on a project that earns less than a savings account. The retention is justified by the return on the money they kept, which you can only judge over several years.
What to remember
- Write margins, not only rupees. A fatter top line can hide a thinner business.
- Fixed costs make profits swing harder than sales, in both directions.
- Depreciation and dilution are costs. An ‘adjusted’ profit should explain each item it removes.
- Separate operating profit from one-time other income.
- Pair every profit figure with the share count it has to be divided by.