Reading the financial statements is important to understanding businesses. For beginners, it may be daunting at first. I will try my best to make it come alive with case studies!
For this post, we will focus on the top three lines – Revenue, Cost of goods, and Gross profit. Now, imagine you are running a lemonade stall:
Revenue is the total sales made from selling those lemonades.
Revenue = Price per glass x Number of glasses sold
Cost of goods is the cost of the ingredients and labor costs for making that lemonade. It would include the cost of lemons, water, ice, and syrup. If you hired someone, their wages would be included here too!
Gross profit is simply the difference between revenue and cost of goods. If you made $100 from selling lemonades and it cost you $40 for the ingredients, your gross profit is $60!
Gross profit = Revenue – Cost of goods
Gross Profit Margin
You’ll frequently see the term Gross Profit Margin (GPM). Which is simply gross profit/revenue x 100%.
It signifies pricing power. The higher it is, the more pricing power you have. In our lemonade example, our GPM is 60%. Which means we make our lemonade for $0.40 and sell them for $1.
It could also reflect cost structure and production efficiency. As companies scale, they may have more bargaining power over their suppliers and demand lower prices (e.g., Walmart & Costco).
Low Margins Doesn’t Mean It’s Bad
Costco is one of America’s largest retail chains and its mission statement is “To continually provide our members with quality goods and services at the lowest possible prices.”
And we can see this being echoed in their annual report as well. They outline their strategy as follow:
Does Costco walk the talk? Let’s take a look at their income statement. Their gross profit margin is only 11%. This means that when you bulk purchase toilet rolls at $15, it cost the company $13.35.
How do they fare when compared to Walmart? Did they fulfill their mission – to provide the lowest possible price? As we can see, Walmart’s gross profit margin is at 24%. The same toilet roll that cost you $15 at Costco, would cost you $17.57 at Walmart!
What about Target? Their gross profit margins are at a staggering 28%—meaning the toilet roll would cost $18.54!
By studying the gross profit margin, we can see that Costco is truly the “pricing authority” in retailing. This explains their success in winning over customers and delivering returns for shareholders (20% CAGR) over the past 10 years. Who wouldn’t want to get the best prices?
Importantly, we can see that low gross profit margins doesn’t mean it is a bad business. For Costco, low prices are their competitive advantage. They pass all the cost savings to consumers. What matters is the consistency of the margins. If it declines, we will need to investigate and understand if its pricing power is being eroded.
This brings us to our next case study on Victoria’s Secret, a subsidiary of L Brands.
Declining Margins Almost Always Spells Trouble
Victoria Secret used to be regarded as a premium brand. Since the late 1990s, Victoria’s Secret has been one of the best-known and most talked-about brands in the country.
Robert Cialdini aptly points out, a higher price truly can influence us psychologically into perceiving the product as more valuable. For premium brands such as Victoria Secret, Louis Vuitton, and Hermès, prices send a strong signal of value in the products.
For a business whose competitive advantage lies in its brand, the gross profit margin tells us whether its pricing power is intact. And here we can see that Victoria Secret heavily discounted its products in an attempt to clear its inventory. The gross profit margin declined rapidly from 43% to 34.5%.
The company’s competitive advantage (moat) has since been breached. A tarnished brand is difficult to rebuild. Its share price has since shrunk from $74 to $15, an 80% decline.
Other times, a declining margin may suggest that the company is a price-taker. As the cost of goods increases, the company is unable to raise the prices and pass down the additional costs to consumers.
Making Sense of Revenue
The revenue is one of the most helpful figures in evaluating management’s growth plans. In the business section, management will provide information such as the number of stores and average square feet—as Ulta Beauty did.
Ulta has a total of 12,540,000 (10,000 sq feet x 1,254 stores). And they made $7.4b in revenue as stated in their 2019 annual report. That comes up to $590 per square feet made per year!
Measure this figure against past years—if revenue made per square feet has been rising, great! It means the company has more room for growth. If it’s declining, it may suggest that the company has over expanded.
I would also do this for premium brands, to measure if they are diluting the brand by lowering prices. For Ferrari, I would take revenue divided by the number of cars sold. If the average revenue per car is going down, that may be a red flag!
Growing Gross Profit per Customer
Companies that are able to keep growing its gross profit per customer often signals a high-quality company. To achieve this, the company must have recurring revenue and the ability to scale (i.e. grow).
SaaS companies such as Adobe and Autodesk have been able to raise prices by delivering additional features to their software without a corresponding rise in the cost of goods. And the revenue is extremely sticky as consumers pay subscription fees to enjoy the functionalities.
For consumer staples, Starbucks has been able to enjoy this with its premium brand. They have been able to raise prices at a faster clip than the cost of goods. The revenue is stickier than other restaurants as coffee is a staple for some and often consumed daily. Starbucks has also been able to improve consumer loyalty with its membership program.
Steady Compounding Updates
Do let me know if this has been helpful or if there are any other topics you are interested in by commenting below!
The next section on understanding income statement would be on operating income, where we will take into account other expenses such as depreciation, amortization, rental, marketing, and more!