You will be able to break an income statement into revenue drivers and margins and remove one-off items.
The results announcement said Larkspur's net profit rose 60% in FY5. Marcus read the income statement line by line and found that a third of the increase came from selling a property, and that operating margin had only climbed back to where it was two years earlier. Neither fact was hidden. Both needed someone to take the income statement apart rather than read its last line.
All figures are made up and in S$ millions unless stated.
Revenue isn't all the same quality. Revenue under contracts that repeat, such as subscriptions, maintenance agreements or multi-year supply deals, is more predictable than one-off sales, and investors pay more for predictability. Where a company discloses the split, in the segment note or the operating review, carry it into your model as separate lines.
Larkspur's operating review split its revenue in two. About 95% came from parts and modules supplied under multi-year agreements with its equipment-maker customers. The agreements set prices and terms, but not volumes, which rise and fall with the chip cycle. The other 5% came from one-off engineering and tooling work, which is lumpy and hard to forecast. So even Larkspur's repeating revenue isn't a subscription. It repeats in the sense that customers rarely leave, not in the sense that the amount is fixed.
Five years of revenue show the cycle: 300 in FY1, 350 in FY2, 425 in FY3, 360 in FY4 and 400 in FY5. From FY1 to FY5 that's growth of about 7.5% a year compounded, with a fall of about 15% in FY4 in the middle.
Work down the income statement as a set of margins, each as a percentage of revenue.
Gross margin is revenue minus cost of sales, the direct cost of making the product, so for Larkspur in FY5 it's 400 minus 280, or 120, which is 30% of revenue. Operating margin also takes away overheads, research and selling costs: Larkspur's operating expenses of 64 left operating profit, or EBIT, of 56, a 14% operating margin. Net margin is whatever survives interest and tax, and reported net profit of 48 on revenue of 400 is 12%.
The gaps between the margins tell you where costs sit. Larkspur's costs are mostly in cost of sales: materials, machine time and factory labour, which rise and fall partly with volume. Its overheads are smaller and more fixed.
That shape explains the cycle in profit. When revenue falls, the fixed part of cost doesn't, so margins fall faster than revenue. Larkspur's operating margins over the five years were 12%, 14%, 16%, about 11% and 14%. Operating profit went from 68 in the peak year to 40 the year after, a fall of about 41% on a 15% fall in revenue. Analysts call this effect of fixed costs operating leverage, and it's why cyclical companies look cheapest at the peak of their earnings, which module 9 comes back to in lesson 9.2, When each multiple misleads: cycles, leverage and accounting.
Lesson 6.6, Adjusted earnings and how to reconcile them to reported figures, separated fair adjustments from unfair ones. In the model, apply the result: remove the true one-offs and keep the recurring charges.
For FY5, the only true one-off was the gain of 6 on selling a property, which sits below operating profit. Profit before tax was 58: operating profit of 56, plus the gain of 6, minus interest of 4. Tax of 10, about 17% of that, brought net profit to 48. In this example the gain carried no tax, so taking it out gives underlying net profit of 42 and an underlying net margin of 10.5%.
That changes the story. Reported net profit rose from 30 in FY4 to 48, the 60% in the headline. Underlying profit rose from 30 to 42, about 40%. The business did recover, by less than the headline said, and the 40% came on revenue growth of only about 11%, the same fixed costs now working in Larkspur's favour.
Do the same check for every year in your history. A gain or impairment in any one year distorts the trend you'll use to set your forecast.
Singapore-incorporated companies listed on SGX prepare their accounts under SFRS(I), Singapore Financial Reporting Standards (International), which are identical to IFRS. So Larkspur's revenue, cost of sales and operating profit are built on the same rules as a European or Australian competitor's, and you can compare margins line for line.
US companies use US GAAP, which differs in places, and some SGX-listed companies incorporated elsewhere use other standards. When you compare across the two, check how each treats leases, development costs and one-off items before you trust a margin gap. Lesson 9.3, Choose a peer group that is really comparable, covers the rest.
Now take five years of your own company's income statement and restate them with the one-offs removed, ready for the margin columns.
Restate five years of your company's income statement with one-off items removed and calculate each margin.
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