Two accounting rules to Understand Balance Sheets

In order to understand the Balance Sheets, you must be familiar with the following two fundamental accounting rules:

• For every debit there must be a credit.
• Balance Sheet assets are debit balances and Balance Sheet liabilities are credit balances.

Depreciation

Fixed assets are assets that will have a value to the business over a long period, usually understood to be any time longer than a year.

They do usually lose their value:

• either with the passage of time (e.g. a lease),
• with use (e.g. a piece of machinery that wears out) or
• due to obsolescence (e.g. computers).

Therefore, they are written off over a number of years.

Depreciation is a book entry and no cash is involved.

The entry is:

• debit depreciation (thus reducing profit)
• credit the asset (thus reducing the value of the asset).

Fixed assets are grouped together in the Balance Sheet and one total is given for the net value of all of them.

Examples of fixed assets are:

• freehold property
• plant and machinery
• computers
• motor vehicles

Prudent Reserves

When something happens that causes an asset to lose value, it is written off.

• For example, if some stock (asset) is stolen, the value of the stock in the Balance Sheet is reduced.

The same thing must happen if a prudent view is that an asset has lost some of its value.

• For example, if some of the stock is obsolete and unlikely to sell for full value.
• Normally, the Balance Sheet will just show the reduced value, which will be explained with notes.

Stock reserve

The creation of a stock reserve reduces the profit.

• If it is subsequently found that the reserve was not necessary, the asset is restored to its full value and the profit is correspondingly increased in a later period.

Bad debt reserve

It is often necessary to create a bad debt reserve to cover money that may not be collectable from customers.

• This bad debt reserve reduces the profit.
• For example, loan loss reserve or provision by the banks.

Working Capital

This is the difference between current assets and current liabilities.

It is extremely important.

• A business without sufficient working capital cannot pay its debts as they fall due. 
• In this situation it might have to stop trading even if it is profitable.

Possible alternatives might include:

• raising more capital,
• taking out a long-term loan, or
• selling some fixed assets.

Try to get a long-term loan

A bank overdraft is repayable on demand.

A long-term loan is repayable at a future date, or more likely in installments over a period.

If times are hard (or even if they are not), there are obvious advantages to having a long-term loan instead of an overdraft, or as well as an overdraft.

So long as you do not breach the terms of the agreement, you cannot be forced to pay it back quickly.

This gives you peace of mind.

Get your customers to pay on time

Take it seriously and give the task the time and resources necessary.

Tel yourself that you are entitled to be paid on time and that you are being cheated if you are not.

Agree the terms in advance and make it clear that they should be honoured.

A good motto is "ask early and ask often".

If all else fails take legal action.

A tough but fair line will probably not upset your customers, but it might.

Ask yourself if you really want those customers.

Never forget the importance of working capital

Working capital is the difference between assets realizable in the short term and liabilities payable in the short term.

It includes cash held and money owed.

Quickly realizable assets are the next best thing to cash.

If you can get the working capital right, you should be safe.

Try hard to achieve this.

Never forget the importance of cash

"Cash is King"

Losses may eventually force a business to close but in the short term, lack of cash is likely to be the critical factor.

You should hoard cash and you should plan your cash flow very carefully - daily if necessary.

Talk to your bank early and explain your plans.

Cash should be the number one priority.

Keep an eye on the accounting ratios

These are always useful, but are particularly so if a business is in trouble.

You should know what is acceptable and you should monitor trends over a period.

If things are going wrong, this may spotlight the dangers and indicate where remedial action is needed.

Gearing and the number of days' credit given and taken may be especially useful.

Do not overlook the value of marginal costing

When times are tough there is likely to be pressure on sales and margins.

In this situation, marginal costing could be very helpful.

It may be essential to cut fixed costs and it may be necessary to adjust prices.

Marginal costing should help you make the right decisions.

Prevention is better than cure

It is good to be able to get out of financial difficulties but it is better not to have financial difficulties in the first place.

The intelligent and timely use of financial information can help avoid them.

It is tempting not to plan and budget in the good times, but it is probably a mistake.

Do not drown in financial detail

You may be given a vast amount of financial information, particularly if you work for a large company.

This could be because someone believes that it is useful or just because the system automatically provides it.

Remember the old saying about not being able to see the wood for trees.

Learn to concentrate on what is important and give little or no attention to the rest.

That way you will get the key financial information and still have time to do your job.

This is particularly important when things are tough and your time is at a premium.

Use the financial figures quickly

Financial data should help you survive tough times and it will be more valuable if you can get it quickly and use it quickly.

It is sometimes better to have slightly inaccurate or incomplete information quickly than perfect information some time later.

Talk this over with your financial colleagues.  Make time to look at it and act on it when it comes.

Be sceptical about expert advice

Experts will probably give you good advice, but do not overlook the possibility that they may be mistaken.

• For centuries, experts said that the world was flat, but Christopher Columbus proved them wrong.
• Experts (who were paid a lot of money) or some of them at least, failed to foresee and plan for the economic mess that has plaqued much of the world in 2008/2009.

You may not be a financial expert but you are probably an expert at your particular job.  If the advice feels wrong, perhaps it is wrong.

Investment Decisions

Some investment decisions are easy to make.

• Perhaps, a government safety regulation makes an item of capital expenditure compulsory.
• Or perhaps, an essential piece of machinery breaks down and just has to be replaced.

Many other investment decisions are not nearly so clear cut and hinge on whether the proposed expenditure will generate sufficient future cash savings to justify itself.

There are many very sophisticated techniques for aiding this decision.  Here are three techniques that are commonly used:

• Payback
• Return on investment
• Discounted cash flow.

Payback

This has the merit of being extremely simple to calculate and understand.  It is a simple measure of the period of time taken for the savings made to equal the capital expenditure.

Return on investment

This takes the average of the money saved over the life of the asset and expresses it as a percentage of the original sum invested.

Discounted cash flow.

This technique takes account of the fact that money paid or received in the future is not as valuable as money paid or received now.  For this reason, it is considered superior to payback and to return on investment.  However, it is not as simple to calculate and understand.  Discounted cash flow involves bringing the future values back to its Net Present Value.

Accounting for a Major Project Lasting 4 Years in the Construction Sector

In accounting, costs must be fairly matched to sales.

This is so that the costs of the goods actually sold, and only those costs, are brought into the Profit and Loss Statement.


A Major Project lasting 4 years

Contractor will be paid $60 m
Costs over the 4 years are expected to be $55 m
Anticipated profit is $5 m.

It is almost certain the contractor will receive various stage payments over the 4 years.

This poses a multitude of accounting problems and there is more than one accounting treatment.

The aim must be to bring in both revenue and costs strictly as they are earned and incurred.

Accounting standards provide firm rules for the published accounts.

1. The full $60 m revenue will not be credited until the work is completed.
2. In fact, there will probably be a retention and it will be necessary to make a reserve for retention work.
3. The final cost and profit may not be known for some years.
4. Conventions of prudent accounting should ensure that profits are only recognized when they have clearly been earned.
5. Losses on the other hand should be recognized as soon as they can be realistically foreseen.  

Failure to act on this convention has led to scandals and nasty surprises for investors.  The collapse of some big companies being examples.


Prudence and the matching of costs to income - the Principles:

• Accruals are costs incurred, but not yet in the books.
• Prepayments are costs in the books, but not yet incurred.
• Profit is reduced by expected bad debts.
• Depreciation is a book entry to reduce the value of fixed assets.
• Profit accounting may differ from cash accounting.
• Profit Statements should be prudent.
• Costs must be matched to income.

Additional Notes:

Accruals (costs not yet entered)
Invoices are submitted after the event and some will not have been entered into the books when they are closed off.  This problem is overcome by adding in an allowance for these costs.  The uninvoiced costs are called accruals.

An example is a company whose electricity bill is around $18,000 per quarter.  Let us further assume that assume that accounts are made up to 31 December and that the last electricity bill was up to 30 November.  The accountant will accrue $6,000 for electricity used but not billed.  If electricity invoices in the period total $60,000 the added $6,000 will result in $66,000 being shown in in the Profit Statement.

Prepayments (cost entered in advance)
Costs may have been entered into the books for items where the benefit has not yet been received.  

For example, consider an insurance premium of $12,000 paid on 1 December for 12 months's coer in advance.  If the Profit Statement is made up to 31 December the costs will have been overstated by 11/12 x $12,000 = $11,000.  The accountant will reduce the costs accordingly.  These reductions are called prepayments.

Bad debt reserves and sales ledger reserves
Many businesses sell on credit and at the end of the period of the Profit Statement money will be owed by customers  Unfortunately not all this money will necessarily be received.  Among the possible reasons are:

• bad debts
• an agreement that customers may deduct a settlement discount if payment is made by a certain date.
• the customers may claim that there were shortages, or that they received faulty goods; perhaps goods were supplied on a sale-or-return basis.

The prudent accountant will make reserves to cover these eventualities, either a bad debt reserve or sales ledger reserve.  Sales (and profit) will be reduced by an appropriate amount.

Time will tell whether the reserves have been fixed at a level that was too high, too low, or just right.  If the reserves were too cautious there will be an extra profit to bring into a later Profit Statement.  If the reserves were not cautious enough there will be a further cost (and loss) to bring into a later Profit Statement.

Buffett slams Wall Street 'monkeys', says hedge funds, advisors have cost clients $100 billion

Andrew Harrer | Bloomberg | Getty Images

Warren Buffett, chairman and chief executive officer of Berkshire Hathaway Inc.

Warren Buffett on Saturday devoted more than four pages of his 29-page annual shareholder letter to criticism of active managers on Wall Street, excoriating what he perceived as exorbitant fees they charge for returns that fail to live up to lofty assumptions.

Meanwhile the legendary stock picker extolled the virtues of passive investing and its advantages for regular investors. The 'Oracle of Omaha' even compared active managers to monkeys, and estimated that financial advisors, in their futile search for ways to beat the market, had cost clients $100 billion in wasted fees in the last 10 years.

"When trillions of dollars are managed by Wall Streeters charging high fees, it will usually be the managers who reap outsized profits, not the clients," stated the widely-read letter released on Saturday morning. "Both large and small investors should stick with low-cost index funds."

Chris Kleponis | Bloomberg | Getty Images

'The results were dismal'

Buffett started this critical section of the letter with an update on a 10-year wager against Wall Street's active management he made nine years ago, with the proceeds going to a charity. This is how the billionaire described his original challenge:

"I publicly offered to wager $500,000 that no investment pro could select a set of at least five hedge funds – wildly-popular and high-fee investing vehicles – that would over an extended period match the performance of an unmanaged S&P-500 index fund charging only token fees. I suggested a ten-year bet and named a low-cost Vanguard S&P fund as my contender. I then sat back and waited expectantly for a parade of fund managers – who could include their own fund as one of the five – to come forth and defend their occupation. After all, these managers urged others to bet billions on their abilities. Why should they fear putting a little of their own money on the line?"

To his surprise, only one person stepped up to take the other side of the bet: Protégé Partners' Ted Seides, a 'fund of funds' manager. According to the bet, Seides selected five funds of hedge funds, whose results after fees would be averaged and compared to Buffett's selection, a Vanguard S&P index fund.

Here's what happened, according to the letter: 

"The compounded annual increase to date for the index fund is 7.1%, which is a return that could easily prove typical for the stock market over time...The five funds-of-funds delivered, through 2016, an average of only 2.2%, compounded annually. That means $1 million invested in those funds would have gained $220,000. The index fund would meanwhile have gained $854,000."

In fact, none of the basket of funds came even close, according to Buffett:

Source: Berkshire Hathaway 2016 shareholder letter

"The results for their investors were dismal – really dismal. And, alas, the huge fixed fees charged by all of the funds and funds-of-funds involved – fees that were totally unwarranted by performance – were such that their managers were showered with compensation over the nine years that have passed," Buffett wrote. "As Gordon Gekko might have put it: 'Fees never sleep.'"

Investors seem to be heeding Buffett's anti-active advice, as more than $20 billion flowed out of U.S. active equity funds in January despite a rising stock market, according to Morningstar. In the last 12 months, more than half a trillion dollars have flowed into passive funds, while active funds have experienced outflows, Morningstar's data showed. 

In his letter, Buffett criticized how the whole Wall Street complex is still set up to send pension funds, endowments and other investor types into under-performing active vehicles. He claimed that the wealthy investor classes are getting ripped off the most:

"In many aspects of life, indeed, wealth does command top-grade products or services. For that reason, the financial 'elites' – wealthy individuals, pension funds, college endowments and the like – have great trouble meekly signing up for a financial product or service that is available as well to people investing only a few thousand dollars. This reluctance of the rich normally prevails even though the product at issue is –on an expectancy basis – clearly the best choice. My calculation, admittedly very rough, is that the search by the elite for superior investment advice has caused it, in aggregate, to waste more than $100 billion over the past decade. Figure it out: Even a 1% fee on a few trillion dollars adds up. Of course, not every investor who put money in hedge funds ten years ago lagged S&P returns. But I believe my calculation of the aggregate shortfall is conservative."

Buffett stated that he knows of only 10 managers that he spotted early on who could outperform the S&P 500 over the long term, and they did so. He acknowledged there are more out there who may be able to beat the market, but they are the clear exception. 

"Further complicating the search for the rare high-fee manager who is worth his or her pay is the fact that some investment professionals, just as some amateurs, will be lucky over short periods," Buffett wrote.

"If 1,000 managers make a market prediction at the beginning of a year, it's very likely that the calls of at least one will be correct for nine consecutive years. Of course, 1,000 monkeys would be just as likely to produce a seemingly all-wise prophet. But there would remain a difference: The lucky monkey would not find people standing in line to invest with him."

The billionaire heaped praise on Jack Bogle, the founder of the Vanguard Group who started the first index fund 40 years ago.

"If a statue is ever erected to honor the person who has done the most for American investors, the hands down choice should be Jack Bogle," the letter stated. "In his early years, Jack was frequently mocked by the investment-management industry. Today, however, he has the satisfaction of knowing that he helped millions of investors realize far better returns on their savings than they otherwise would have earned."

"He is a hero to them and to me," Buffett added.


John Melloy | @johnmelloy
Saturday, 25 Feb 2017
CNBC.com

http://www.cnbc.com/2017/02/25/buffett-slams-wall-street-monkeys-says-hedge-funds-cost-100-billion.html

Why did Buffett buy Apple Inc. ( AAPL)? - A Cash Cow that turned 24.8% of its Revenues into Free Cash Flow for its Owners.

At the price of US 139.84 per share and with 5,500 million shares outstanding, Apple is priced by the market at a whopping US 769.12 Billion.

It is the company with the highest market capitalisation in a stock market in the world today.

Apple continues to innovate in its products and it is expected to deliver some new surprises in the future.

Despite some negative news in recent years, it has proven its critics wrong in growing its revenues, profit before tax and EPS share over the last 5 years.

The revenue growth showed consistency, however, the profit before tax and EPS were more volatile and less consistent, being affected by efficiency and costs leading to profit margins that were variable over the period.

Though its revenues had grown from US 156 billion in its FY 2012 to US 214 billion in its FY 2016, its net income grew from US 41.7 billion to US 45.7 billion over the same period.

Its profit before tax margins continued to be maintained at high levels of 28.6% and its latest ROE was 38.3%.

Apple started its share buybacks over the years and had reduced the number of shares outstanding from 6,617 million shares in 2012 to 5,500 million shares in 2016.

Due to its huge free cash flow generated yearly and its huge cash reserves, this share buyback should benefit the shareholders who are still holding to its shares.

Apple distributed little dividend in the past.  In 2012, its dividends were US 2.5 billion.  Since 2013, Apple had distributed dividends of US 10.6 billion, US 11.1 billion, US 11.6 billion and US 12.2 billion yearly to 2016.

Over these 5 years from 2013 to 2016, its dividend payout was a total of 22.1% of its earnings.

Apple still retains a lot of its earnings, some being used to buyback its own shares.

This company is a true cash cow.  Its FCF for the year ending Sept 2016 was US 53.1 billion on a revenue of US 214 billion.  This gave a FCF/Revenue of 24.8%.  A remarkably high and cash generating company.

At today's market capitalisation of US 769.12 billion (US 139.84 per share), its FCF to market cap yield is 6.89%.

At today's price of US 139.84 per share, and using the EPS of FY 2016 of US 8.31 per share, Apple is trading at a PE of 16.8x.

When Warren Buffett bought into Apple at the end of 2016, its share price was around US 110 per share.

At US 100 per share then, Warren Buffett bought into Apple which is a great company at a fair price.  At that price, the upside and downside were about even.  The dividend yield was 2.4% and the potential total upside return around 11.1% per year (2.4% from dividends and 8.7% from capital appreciation) for the next 5 years.

At US 139.84 today,  the upside is much less compared to the downside.  The dividend yield is 1.9% and the total projected potential return around 4,5 %per year (2.6% from dividends and 1.9% from capital appreciation) over the next 5 years.

Aeon Credit (22.3.2017)

The revenue, profit before tax and EPS continue to grow.

In its latest quarter, it grew its quarterly revenue 14% and its quarterly EPS 27.4% when compared to the previous year same quarter.

Its share price peaked at RM 18.86 per share in 2013.

Since then its share prices have been range bound between RM 10 to RM 15 per share.

Its EPS continued to grow at a good rate during the same period from 93.1 sen per share to 158.5 sen per share.

The rising EPS and the flat share prices over the last 3 years, resulted in Aeon Credit trading at very low PE of below 10.

At today's closing price of RM 16.60 per share, it is trading at a PE of 10.5.

This stock pays dividend over the years.  Its dividend payout ratio has been around 38%.

It has increased its dividends yearly over the years from 25 sen per share in 2012 to 59.5 sen per share in 2016 (more than double over this period).

At its present price of RM 16.60 per share, its dividend yield is 3.58%.

This dividend yield should appeal to those who are investing for income too.

Projecting into the future, Aeon Credit should continue to grow its revenues, profit before tax and EPS.

Those who own Aeon Credit for the long term should enjoy a satisfactory total return from its capital appreciation and its growing dividends.

Benjamin Graham's teachings on Market Fluctuations and your investing

Market Fluctuations

            Fluctuations of Common Stock Prices

Since common stocks are subject to wide price swings, the investor should seek to profit from these opportunities.  However, attempting to time the market usually ends in unsatisfactory results.  Graham believes that market timing is pure speculation and is not an investing activity.  The best an investor can do is the change the bond and stock proportions in his portfolio after major market swings. 

Formulas do not work, although they have been in vogue since the 1950s.  When the market reached new highs in the mid-1950s, many formula investors sold their equities according to formula only to witness the market grow increasingly higher.  Any approach to the market that is easily described is sure to fail (except for Graham’s method). 

The investor also can focus on the price of a security. Graham recommends this practice.  Short-term fluctuations should not matter.  Over a period of 5 years, the investor should not be surprised if the average value of his portfolio increases more than 50% from its low point or decreases 1/3 from its high point.

Market advances and declines tempt investors to make foolish decisions.  Varying the proportion of stocks and bonds between the 25%-75% ratio occupies an investor’s time during turbulent markets and prevents him from making gross errors in judgement.  The true investor takes comfort that his actions are opposite from the actions of the crowd.

The better a firm’s record and its prospects, the less relationship that its price will have to its book value.  The more successful the company, the more likely its share price is to fluctuate.  More often than not, a fast growing firm’s market price will exceed its intrinsic value.  So, the better the quality of the stock, the more speculative it will be.  This explains the erratic price behavior of some of the most successful and impressive enterprises, such as IBM and Xerox.

The investor should purchase issues close to their tangible asset values and at no more than 33% above that figure.  These purchases logically are related to a company’s balance sheet and not to its earnings.  Any premium over book value may be thought of as a fee for liquidity that accompanies any publicly traded stock.   

            Just because a stock sells at or below its net asset value does not warrant that it is a sound purchase.  In addition to below market values, the investor also must demand a strong financial position, a satisfactory p/e ratio, and an assurance that the firm’s earnings will be sustained over the years.  This is not an entirely difficult bill to fill except under dangerously high market conditions.  At the end of 1970 more than half of the DJIA met these investment criteria.  However, the investor will forgo the most brilliant, high growth prospects.

            With a portfolio purchased at close to book value, the investor can take a more detached view of market fluctuations.  In fact, so long as the earning power of the portfolio remains satisfactory, the investor can use these market vagaries to buy low and sell high.

As seen with the stock fluctuations of A & P over many years, the market often goes wrong.  Although the stock market may fall, a true investor is rarely forced to sell his shares.  Rather, the investor is free to disregard the market quotes.  Thus, the investor who allows himself to be unduly worried about the market transforms his basic advantage into a disadvantage.  In fact, the investor who owns common stock owns a piece of these companies as a private owner would, and a private owner would not sell his business when it is undervalued by the market.  A quoted stock provides an option for the investor to sell at a given price and nothing more.  The investor with a diversified portfolio of good stocks should neither worry about sizeable declines nor become excited about sizeable advances.   An investor never should sell a stock just because it has gone down or purchase it because it has gone up.

Graham provides the parable of “Mr. Market”, who like the stock market, quotes you a price for your shares each and every day.  Mr. Market will either buy your shares or sell you his.  The price will depend upon Mr. Market’s mood.  You can ignore his efforts, or you can take advantage of him when he quotes you a price that you believe is priced advantageously.  Finally, one should not forget the effect of management on a firm’s results.  Good management produces acceptable results and bad management does not.

Fluctuation of Bond Prices

            Short-term bonds, defined as those with a duration of less than 7 years, are not significantly affected by changes in the market.  This applies to US Savings Bonds, which can be redeemed at anytime.  Long term bonds, however, may experience wide price swings as a result of fluctuations in the interest rate.  Thus, long term bonds may seem attractive when discounted, but this practice often leads to speculation and losses.

Low yields correspond with high bond prices and vice versa; prices and yields are inversely related.  The period from 1960 to 1975 is marked by reversing swings in the price of bonds so much so that it reminded Graham of Newton’s law: “every action has an opposite and equal reaction.”  Of course, nothing on Wall Street actually occurs the same way twice. 

Graham acknowledges the impossibility of attempting to predict bond prices, even if common stock prices were predictable.  Therefore, the investor must choose between long- term and short-term bonds chiefly on the basis of personal preference.  If the investor wishes to ensure that his market values will not decrease, then the investor is best served by US Savings Bonds.  With higher yield long term bonds, the investor must be prepared to see their market values fluctuate. 

Convertible issues should be avoided.  Their prices fluctuate widely and unpredictably based upon the price of the underlying common stock, the credit standing of the firm, and the market interest rate.  Because convertible issues experience huge swings in market value, they are largely speculative investments.