Sunday, July 24, 2022

How to invest - part 1. Preparation - How - Sixth Part

Today will be the third item on what to look at, financially: The net profit margin.

Net profit margin is calculated by deducting from your revenue, the following items:
1. cost of goods sold
2. operating expenses aka overheads oka fixed costs
3. depreciation and amortization, interests, and taxes

You may recall from the previous post that gross profit is obtained by deducting your cost of goods sold from your revenue. So, your net profit is really just your gross margins, less all costs other than costs of selling your goods.

Picture this: you sell lemonade for a living, so your revenue is the sales amount from all the cups of lemonade sold. Your gross profit is your sales, less the costs of the lemonades, water, sugar, salt, ice, cups, i.e. all the costs that you need to pay in order to serve that lemonade to your customers. 

Now, other than the costs mentioned, there are other costs you gotta accommodate, in order to operate - these are the costs you would have to incur in running the biz, whether or not you make money - such as the lemonade stand, the icebox, the ice in the icebox to keep whatever in the icebox ice-cool, chair(s) for you to sit on while waiting/tending to customers, a table cloth to place your lemonading equipments, the cash box/register, and the biz license (lol I doubt there needs to be a license for running a lemonade stand but let's just assume the gov is serious about regulating the lemonade business). These are your operating costs - there can be a few variants to this name but the concept is wtv cost you pay to ensure the biz can operate, whether or not you make a sale.

Then there are the truly boring stuff - especially if you run a cash business coz these costs are stuff you don't quite see and feel (for taxes, it's stuff you neither want to see nor feel really). Depreciation and amortization, in a nut shell, is you recognizing your assets this year won't be worth as much the next year - this is because of wear and tear, or the equipment becoming older/obsolete, and because accountants generally need to do something - this recognition is manifested in the real world by deduction against your income. Depreciation is for physical assets like the lemonade stand, jug to store lemonade, chairs etc, while amortization applies to intangible assets like your lemonade stand brand, the website, and trademark of your lemonade stand name.

Think about the car you own - you first got it for say, $100,000.00, then in the 2nd year, you find that the market rate for your car in the second hand market for a two year old car is only $85,000.00 - it's not exactly the same thing but you can think of it as a parallel. This part really becomes useful for tax breaks and for audits.

Interests, well it's pretty straightforward - the interests on any loans you make also need to be deducted against your income. This part also becomes really useful for tax breaks.

Coming to tax, well I don't have much to say other than I wish there wasn't tax but that would mean governments will cease to operate (and is that such a bad idea?). Suffice to say, you make income, there will be a tax on that and there are some steps you can take in an endeavor called tax planning - unfortunately my knowledge, will, and patience for tax matters are as deep as the thickness of an A4 paper and I shall not go any further - just know that tax is always present, and any listed company has to pay tax, and if they don't, they get in big trouble, usually existence-threatening trouble - so any listed company will not or will try their best to keep their taxes in good order, making this an item the least of your worries.

Also, there's a reason why, in the financial statements, the depreciation and amortization, interests and tax are lumped together with income, under a line called EBITDA or earnings before interest, tax, depreciation and amortization.  This is really just taking your gross profit, and deducting your operating expenses to get your total income before considering the effects of depreciation and amortization, and any interests on loans and taxes. 

You can consider this to be your net profit (gross profit after deducting operating expenses), but without the accounting effects of depreciation and amortization - which in theory should give you a "cleaner view of your income"

As a side note,  depreciation and amortization doesn't really affect you in a physical way coz it does not disrupt your cashflow right? You receive cash for selling lemonade (revenue), then you minus of the costs of buying lemons, and preparing & storing the lemonade (cost of goods sold), and after that, you pay for the chairs, banners, and the lemonade stand itself (operating expenses) . No where in this process will you need to pay someone or something the amount you think that your lemonade stand will decrease come next year, or by the amount you estimate your car will be worth less next year. 

Popularised during a time when leveraged buyouts were the rage, EBITDA became the goto number for evaluating a company coz :
1. leveraged buyouts, as the name implies, made use of leverage or high amounts of debt to buy a company - a profitable one with good cashflow
2. As high amounts of debts were issued, naturally the biggest chunk of expense will be your interests on the debts issued.
3. So, by taking by comparing your EBITDA to your interest ratio cover (basically, how well can your profits cover your interest on debt) - you can sort of tell how well your newly bought biz can meet the loan obligations you incurred to buy it out.

Truthfully speaking, I don't really like looking at net profit margin because at every step of the way, you can change abit, tweak a little, charge more, account for less, increase depreciation/amortization and perform some accounting magic (legal magic mind you) in so many other ways that the initial revenue you get may very well turn out to not be a good indicator of biz performance by the time it is net profit. I believe, more revenue, means good business but that's for another day!

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