Future Profit overrides Current Liquidity. Success or failure?

Ideally, a company can be expected to focus on 2 principal objectives:

1.  Future Profit:  To provide an acceptable and continuing rate of return to investors.
2.  Current Liquidity:  To maintain an adequate level of financial resources to support current and planned future operations and growth.



Future Profit and Current Liquidity

A company can survive without profit as long as it has access to cash.

A profitable company with no cash faces difficulties.

No company can survive for more than a few days with neither profit nor cash.



Future Profit overrides Current Liquidity

A profitable company is less likely to fail than an unprofitable one.

The overriding factor in deciding whether to allow a company to continue in business is its profit potential, which is more important than its current liquidity.

A company with low liquidity and a high profit potential will almost certainly be helped to overcome what may be regarded as a temporary problem.  

A highly liquid company with declining or no profit potential is unlikely to survive for long.   Why should investors leave their funds to dwindle?   The only decision facing such a company is 

• whether to end operations  immediately or 
• to continue and see liquidity and profitability decline until matters are taken out of management's hands.

Net Present Value and Profitability Index

Net Present Value (NPV)

• an indicator of how much value an investment could contribute to the firm
• takes into account the concept of time value of money
• the Present Value Interest Factor (PVIF) Table can be used to calculate present value
• the criteria below should be considered before accepting for rejecting a project or an investment:

NPV > 0  

The investment would add value to the firm.

The project should be accepted.

NPV < 0

The investment would subtract value from the firm, that means the project reduces shareholder wealth.

The project should be rejected.

NPV = 0

The investment would neither gain nor lose value for the firm.

We would be indifferent in the decision whether to accept or reject the project.  This project adds no monetary value.  Decision should be made based on OTHER CRITERIA.

Total Present Value = sum of the discounted value of all future cash flows.

NPV =  Total Present Value - Total Investment.

Probability Index 

The project is not profitable when its profitability index (PI) is less than 1.00

PI = Total Present Value / Total Investment

Project Evaluation

The decisions of where to invest the company's resources have a major impact on the future competitiveness of the company.

Trying to get involved in the right projects is worth an effort, both to

• avoid wasting the company's time and resources in meaningless activities, and 
• to improve the chances of success.

Project evaluation is a process used to determine whether a firm's investments are worth pursuing.

Producing new products, buying a new machine and investing in a new plant are examples of firm's investment.

Investing in those activities involves a major capital expenditure, and management needs to use capital budgeting techniques to determine which projects will yield the most return over an applicable period of time.



Capital Budgeting Factors

Factors involved in capital budgeting are:

1.  Initial Cost
The initial investment or cash capital required to start a project.

2.  Cash In Flow
The estimated cash amount that flows into a business due to operations of the project or business.

3.  Investment Period
The duration of the project and when it is estimated to be completed.

4.  Discount Factor
The value of interest that will be received or charged during the period of the project's execution and it will affect the present value of cash in flows for different years.

5.  Time Value of Money
The idea that a ringgit now is worth more than a ringgit in the future, even after adjusting for inflation, because a ringgit now can earn interest or other appreciation until the time the ringgit  in the future would be received.This theory has its base in the calculation for present value.



Factors influencing investment decision

A firm must make an investment decision to improve or increase the incomes of the company in order to compete in the market.

Investment environments include:

1.  Product development/enhancement
2.  Replacing equipment/machinery
3.  Exploration of new fields or business.



Project Evaluation Methods

Common methods used in evaluating projects, investments or alternatives are:

1.  Payback Period (PBP)
2.  Accounting Rate of Return/Average Rate of Return (ARR)
3.  Net Present Value (NPV)
4.  Profitability Index (PI)
5.  Internal Rate of Return (IRR)


In choosing an investment or project, select the project which generates HIGHER ARR, NPV, PI and IRR; and SHORTER PBP.



APPENDIX:

The Five Rules for Successful Stock Investing 7

Analyzing a Company – The Basics

Because [analyzing companies] can be a daunting task, I suggest that you break down the process into five areas:

1. Growth: How fast has the company grown, what are the sources of its growth, and how sustainable is that growth likely to be?
2. Profitability: What kind of returns does the company generate on the capital it invests?
3. Financial health: How solid is the firm's financial footing?
4. Risks/bear case: What are the risks to your investment case? There are excellent reasons not to invest in even the best-looking firms. Make sure you look at the full story and investigate the negatives as well as the positives.
5. Management: Who's running the show? Are they running the company for the benefits of shareholders or themselves?

You can't just look at a series of past growth rates and assume that they'll predict the future [...]. It's critical to investigate the sources of a company's growth rate and assess the quality of the growth. High-quality growth that comes from selling more goods and entering new markets is more sustainable than low-quality growth that's generated by cost-cutting or accounting tricks.

In the long run, sales growth drives earnings growth. Although profit growth can outpace sales growth for a while if a company is able to do an excellent job cutting costs or fiddling with the financial statements, this kind of situation simply isn't sustainable over the long haul – there's a limit to how much costs can be cut, and there are only so many financial tricks that companies can use to boost the bottom line. In general, sales growth stems from one of four areas:

1. Selling more goods or services
2. Raising prices
3. Selling new goods or services
4. Buying another company

If you don't know how fast the company would have grown without acquisitions, don't buy the shares – because you never know when the acquisitions will stop. Remember, the goal of a successful investor is to buy great businesses, not successful merger and acquisition machines.

The first component of ROA (Return on Assets) is simply net margin, or net income divided by sales, and it tells us how much of each dollar of sales a company keeps as earnings after paying all the costs of doing business. The second component is asset turnover, or sales divided by assets, which tells us roughly how efficient a firm is at generating revenue from each dollar of assets. Multiply these two together, and you have return on assets, which is simply the amount of profits that a company is able to generate per dollar of assets. Think of ROA as a measure of efficiency. Companies with high ROAs are better at translating assets into profits.

ROA helps us understand that there are two routes to excellent operational profitability: You can charge high prices for your products (high margins), or you can turn over your assets quickly.

Return on equity (ROE) is a great overall measure of a company's profitability because it measures the efficiency with which a company uses shareholders' equity – in other words, it measures how good the company is at earning a decent return on the shareholder's money.

http://books.danielhofstetter.com/the-five-rules-for-successful-stock-investing/

Value Investing approach outperformed the market as a whole and Value Investors who stayed the course were rewarded, as least, on a relative basis.

Value investors emphasize on

1.  Real Assets
2.  Current Earnings

They treat prospects for profitable growth with skepticism.

Do not confuse productivity with profitability.  Productivity is not the same as profitability.

[The Internet can be both the friend of productivity and the scourge of profitability.   Airline travelers, for instance, can search more easily for lower fares, more convenient routes, and more generous rewards. Intensified competition almost always lowers prices.]

It is profits that ultimately determine stock prices.

Only firm with unique abilities, companies that enjoy a competitive advantage will reap extraordinary profits.

Are Earnings Coming Back to Earth?

By Jeremy Glaser

Morningstar – Sun, Oct 21, 2012

Corporate earnings have long been a bright spot during this recovery. Even when everything else in the economy looked bleak, corporations seem to keep delivering better-than-expected news quarter after quarter. But is that turning around? So far in this third-quarter earnings season, we've seen disappointing top-line numbers that could be a sign that the momentum in corporate earnings might be beginning to slow.

All things considered, most large firms handled the great recession fairly well. Faced with collapsing sales and an uncertain future, most managers became very defensive. They cut staffing to the bone, shut down unprofitable divisions, paid off debt, and raised additional capital if needed. These moves not only helped keep the lights on during the worst of the downturn, but they positioned firms well for the upturn. As the economy slowly began to come back, the leaner and more efficient companies were able to consistently boost their margins and surprise investors, even when revenue growth remained anemic. The charts below show just how high corporate profits have reached, and how profits have hit an all-time high as a percentage of gross domestic product. Shaded areas on these charts represent U.S. recessions.

US Corporate Profits After Tax data by YCharts

US Corporate Profits After Tax as % of GDP data by YCharts

But high levels of profitability can't go on forever. Eventually firms are going to have to hire more workers, invest in equipment, and face new competitors. Many (including GMO and others) have predicted that margins are due for a mean reversion and that regardless of the strength of the recovery, corporations are going to get squeezed. It's hard to extrapolate too much from the earnings we've seen during the last two weeks, but that squeeze could be starting.

Squeeze Play
To be sure, earnings have not been a disaster so far. According to data from FactSet, of the 98 members of the S&P 500 that have reported earnings so far, 70% have exceeded analyst expectations. But of those 98 firms, only 42% have beaten estimates for sales. During the last four years, an average of 59% of firms had beaten revenue estimates at this point in the reporting cycle. Some of those current misses are being driven by unrealistically high expectations and very strong currency headwinds, but some firms are starting to show signs of weakness. Given that most firms have already cut about as much as they can from their organizations, the drop in sales is likely to eventually lead to a drop in profit as it will be harder to cut deeper to keep profit growing.

One of the highest-profile misses this past week was Google(GOOG), which surprised the market not only with a premature earnings release but also with disappointing results. Revenues were below expectations, and operating costs rose quickly as the firm spent money to launch a new tablet and invest elsewhere in the business. Morningstar analyst Rick Summer thinks that as the firm continues to shift its revenue stream away from ads hosted on its sites toward ads on partner sites, content, and hardware it will become even hard to "gain operating leverage from the business" and increase margins at all. Google was hardly the only tech firm that reported a rough quarter. Microsoft(MSFT) and Intel(INTC) are feeling the impact of slowing PC sales ahead of the Windows 8 launch. International Business Machines(IBM) missed expectations as its revenues declined 5% (partially because of currency headwinds) as the firm launched its mainframe refresh.

Beyond tech, earnings misses could be found in plenty of other sectors. Sales at
McDonald's(MCD) and Chipotle Mexican Grill(CMG) both fell short of expectations. Profitability at the oil-services firms took a big hit this quarter, and
pressure pumping remained challenged. Baker Hughes(BHI) reported a North American margin of 10.5%, a nearly 300-basis-point sequential decline. This is more than Schlumberger's(SLB) 230-basis-point decline but less than
Halliburton's(HAL) 660-basis-point decline.

Sluggish global growth is causing some of these misses, and some are idiosyncratic based on product cycles or one-time issues. Certainly, some of the misses are driven by heightened expectations after such a long stretch of good earnings. But part of it is also that corporate earnings have reached very high levels, and firms are beginning to feel the force of mean reversion. The weak sales this quarter could be the canary in the coal mine that earnings are about to be pressured, too. Even if margins don't come all the way down to historical levels, the reduction in profitability could be a major headwind for investors in the coming years.

http://finance.yahoo.com/news/earnings-coming-back-earth-110000773.html

Understand why Cash is King

'Turnover is vanity, profit is sanity, but cash is reality."

The most common reason that businesses fail is not through lack of profit but through lack of cash.  Many failed businesses are highly profitable but run out of cash.


Profitability versus liquidity.

Whereas profitability is the return generated by a business, liquidity is the ability to pay expenses and debts as and when they fall due.  Liquidity is essential for the financial stability of a business.  A failure to manage liquidity may lead to a business being unable to pay its suppliers and debt holders, which may ultimately lead to bankruptcy.

Cash is like oxygen.

A useful analogy is that profit is like food, whereas cash is like oxygen.  The survival 'rule of threes' states that people can survive three weeks without food, three days without water, but only three minutes without oxygen.  Similarly, a business can survive without profit in the short term but cannot survive without cash.  If employees and suppliers aren't paid the business will not survive for long.

When the cash runs dry.

Although this sounds simple, many businesses don't place enough attention on their liquidity.

• Firstly, businesses aren't realistic when predicting their cash income and cash expenses.  Generally, they overestimate income and underestimate expenses. 
• Secondly, not enough businesses regularly forecast cash flow and foresee problems before they arise.  When they run out of cash, it's often too late.

Ideal goals.

Naturally, both a healthy cash flow and high profits is an ideal goal, but in practice it is not that easy.  

• The short-term goal of a business should be to manage cash flow, and 
• the medium- to long-term goal to manage profitability.

Deciding a suitable cash balance.

Businesses should discover their optimum balance of cash flow.  There is a balance between holding enough cash to meet all short-term demands and utilising cash in more profitable investments.  There is thus a trade-off between holding sufficient liquid assets and investing in more profitable assets.

Successful businesses manage cash flow in the short term and profit in the medium to long term.

Measure Profitability

Measure Profitability

The business with the largest profit is not necessarily the best performer.  Profit should be measured in relation to the size of the investment required to achieve that level of profit.  Therefore, the best measure of profitability is 'return on investment'.

MEASURING 'RETURN'

Gross profit margin % =  Gross Profit / Revenue

This measures the margin made on top of direct costs.  A relatively high sales margin demonstrates the ability of a business either to charge a premium price or to control input costs.  It is useful when benchmarking against similar businesses in the same industry.

Net profit margin % = Operating profit / Revenue

This is similar to gross margin but takes account of operating expenses.  Net profit margin measures the ability to control costs.  Operating profit is preferred to other profit totals, as it exclude finance and taxation costs, which can vary between businesses and years.

MEASURING 'INVESTMENT'

The most common definition of 'investment' is capital employed, which is equity plus non-current liabilities (alternatively, total assets less current liabilities).  Capital employed is effectively the amount invested in a business by both shareholders and debt holders.

Asset turnover (times)  = Annual revenue / Capital employed

This shows how well the finance invested in a business, subsequently invested in assets, has been utilised to generate sales.  It measures the amount of revenue earned from each $1 invested.  Asset turnover demonstrates the number of times assets generate their value in terms of revenue each year.  It is sometimes referred to as a measure of activity.  A relatively high asset turnover could indicate efficient use of assets, although the measure is sensitive to the valuation of assets.

MEASURING RETURN ON INVESTMENT/CAPITAL EMPLOYED

'Return on Investment' (ROI) has many permutations, the most common of which are

• return on capital employed (ROCE); 
• return on net assets (RONA); 
• return on total asset (ROTA); 
• return on equity (ROE); and 
• accounting rate of return (ARR).  

They are all essentially measuring the same thing - profit as a percentage of the investment required to achieve that profit.  ROI is also used in internal investment appraisal.

ROCE = Net profit margin x Asset turnover

ROCE = Operating profit / Revenue) x (Revenue / Capital employed)

Analysing the net profit margin or asset turnover will help to explain a high or low ROCE.

Profit should be measured in relation to the amount of capital employed.


Related posts:

Measuring Business Performance

Measure Profitability

Measure short-term solvency and liquidity

Measure long-term solvency and stability

Calculate investor ratios

Evaluate a business using ratios

Estimate the value of a business

Looking for the firm with an economic moat (Evaluating Profitability)

The first thing we need to do is look for hard evidence that a firm has an economic moat by examining its financial results. (Figuring out whether a company might have a moat in the FUTURE is much tougher.)

What we are looking for are firms that can earn profits (ROIC) in excess of their cost of capital (WACC) - companies that can generate substantial cash relative to the amount of investments they make.

Use the metrics in the following questions to evaluate profitability:

1. Does the firm generate free cash flow? If so, how much?
Firms that generate free cash flow essentially have money left over after reinvesting whatever they need to keep their businesses humming along. In a sense, free cash flow is money that could be extracted from the firm every year without damaging the core business.

FCF Margin:  Divide FCF by sales (or revenues). This tells what proportion of each dollar in revenue the firm is able to convert into excess profits.

If a firm's FCF/Sales is around 5% or better, you've found a cash machine.

Strong FCF is an excellent sign that a firm has an economic moat.

(FCF/Total Capital Employed or FCF/Enterprice Value are some measures.)


2. What are the firm's net margins?
Net margins look at probability from another angle.

Net margin = net income/ Sales

It tells how much profits the firm generates per dollar of sales.

In general, firms that can post net margins above 15% are doing something right.

3. What are the returns on equity?
ROE = net income/shareholders' equity
It measures profits per dollar of the capital shareholders have invested in a company.

Although ROE does have some flaws -it still works well as one tool for assessing overall profitability.

As a rule of thumb, firms that are able to consistently post ROEs above 15% are generating solid returns on shareholders' money, which means they're likely to have economic moats.

4. What are returns on assets?
ROA = (net income + Aftertax Interest Expense )/ firm's average assets
It measures how efficient a firm is at translating its assets into profits.

Use 6% to 7% as a rough benchmark - if a firm is able to consistently post ROAs above these rates, it may have some competitive advantage over its peers.

The company's aftertax interest expense is added back to net income in the calculation.  Why is that?  ROA measures the profitability a company achieves on all of its assets, regardless if they are financed by equity holders or debtholders; therefore, we add back in what the debtholders are charging the company to borrow money.


Study these metrics over 5 or 10 years

When looking at all four of these metrics, look at more than just one year.

A firm that has consistently cranked out solid ROEs, ROA, good FCF, and decent net margins over a number of years is much more likely to truly have an economic moat than a firm with more erratic results.

Five years is the absolute minimum time period for evaluation, 10 years is even better, if you can.


Consistency is Important

Consistency is important when evaluating companies, because it's the ability to keep competitors at bay for an extended period of time - not just for a year or two - that really makes a firm valuable.



These benchmarks are rules of thumb, not hard-and-fast cut-offs.

Comparing firms with industry averages is always a good idea, as is examining the trend in profitability metrics - are they getting higher or lower?

There is a more sophisticated way of measuring a firm's profitability that involves calculating return on invested capital (ROIC), estimating a weighted average cost of capital (WACC), and then looking at the difference between the two.

Using a combination of FCF, ROE, ROE and net margins will steer you in the right direction.


Additional notes:

DuPont Equation

ROA = Net Profits / Average Assets
ROA = Asset Turnover x Net Profit Margin

ROA
= (Sales/Average Assets) x (Net Profits/Sales)
= Net Profits/Average Assets

ROE = Net Profits / Average Shareholder's Equity
ROE = Asset Turnover x Net Profit Margin x Asset/Equity Ratio*

ROE
= (Sales/Average Assets) x (Net Profits/Sales) x (Average Assets/Average Equity)
= Net Profits./ Average Equity

*Asset/Equity Ratio = Leverage