How to Spot Companies in Trouble
You see on CNBC and MSNBC and Bloomberg all the time, the CFO or CEO come on and say, “my company is enjoying a 20% profit with a 25% margin.” You as the viewer think to yourself, well that looks fantastic. Three months later the reporter informs everyone that the company is in bankruptcy court. You think to yourself, well that escalated quickly.
You see, a CEO can publicly say that his company made a profit. You take the sales minus the cost of goods and you get profits. Did the CEO lie? No! In the most simple terms, he is absolutely correct. But, here’s the rub. Costs of goods does not mean the cost of running the business. Cost of goods does not include the cash flow. Without going back over the cash flow statement, I’d like to show how the profit the CEO is talking about is not the “profit”.
- Sales – cost of goods = gross profit ( this is what the CEO is talking about on TV)
- gross margin = gross profit / sales ( this is the margin he quotes )
- operating profit=operating cost – gross profit ( now you get into how much it costs to operate the business on a day to day basis )
- ebitda d= depreciation (physical assets, like a company van) a=amortization (intellectual assets, like a brand name)
- operating margin=operating profit / sales ( this gives a good indicator of where some costs can be cut and how badly the company is operating )
- pbit / ebit = profit before interest and tax / earning before itnerest and tax ( this figure gives us an indicator of how badly taxes and interest are hitting us )
- profit before tax (pbt) = interest – operating profit ( if the company has loans, this gives us the exact amount needed to pay the interest )
- profit after tax (pat)=tax – operating profit ( this figure gives us exactly how much taxes are the profits, this number normally helps a company sets the prices of goods, the consumer ultimately pays the taxes )
- net profit = profit after tax (pat) ( this is the first real end number )
- earnings per share = pat / outstanding shares ( this gives a solid indication of how well a company is doing for investors )
- dividends = % of net profit ( the % is determined by the company, there is no set % )
- payout ratio = dividends / net profit (what percent of the net profit does the firm payout, against this is set by the company, there is no set % )
- retained profits = net profit after dividends ( this is the amount the company keeps after paying out dividends, this amount goes back on the books )
So, you can see that that CEO is a willy coyote, spouting out the gross profits, when it is nowhere near the net profit number. As an investor or an employee, it is your duty to go check the profit and loss statements and the cash flow statements yourself. Remember, if something does not constitute a profit or loss, it doesn’t show up on the profit and loss statement, BUT it will show up on the cash flow statement. That’s why I say the cash flow statement is king.