You will be able to split an income statement into revenue drivers and margins, and strip out one-off items.
Open your company's latest annual report at the income statement and write each line as a percentage of revenue beside it, with revenue as 100%. The net profit figure at the bottom can hide where the profit came from, and the percentages show you where it did.
Larkspur (an invented company; all its figures here are invented and in S$ millions) is listed on SGX and incorporated in Singapore. It supplies parts and modules to chip equipment makers, and its profits are cyclical. Its results announcement says net profit rose 60% in FY5. Marcus reads that, then goes through the income statement line by line and finds two things. A third of the increase, 6 of the 18, came from selling a property. Operating margin had only climbed back to its FY2 level. Larkspur hid neither of these. Both were in the published accounts, and Marcus found them because he read every line as well as the last one.
Some revenue is more reliable than other revenue. Repeating revenue comes from contracts that repeat, such as subscriptions, maintenance agreements and multi-year supply deals. It is more predictable than one-off sales, and investors pay more for predictability. If a company discloses a revenue split in the segment note or the operating review, model each type as its own line.
About 95% of Larkspur's revenue comes from parts and modules sold under multi-year agreements. The other 5% comes from one-off engineering and tooling work, which is lumpy and hard to forecast. The repeating part is not a subscription. The agreements with equipment-maker customers set prices and terms but not volumes, and volumes rise and fall with the chip cycle. The revenue repeats because customers rarely leave, but the amount changes from year to year. Revenue from FY1 to FY5 was 300, 350, 425, 360 and 400. That is growth of about 7.5% a year, compounded, including a fall of about 15% in FY4.
Work down the statement and calculate each margin as a percentage of revenue. Gross margin is revenue minus cost of sales (the direct cost of making the product), as a percentage of revenue. Operating margin also takes off operating expenses: overheads, research and selling costs. What is left is operating profit, also called EBIT. Net margin is what remains after interest and tax, as a percentage of revenue.
For Larkspur in FY5, cost of sales is 280, so gross profit is 400 - 280 = 120. That is a gross margin of 30%. Operating expenses of 64 leave EBIT of 56, an operating margin of 14%. Reported net profit is 48, a net margin of 12%.
The gaps between the margins show where the costs sit. Larkspur's costs sit mostly in cost of sales: materials, machine time and factory labour, which partly rise and fall with volume. Its overheads are smaller and more fixed. When revenue falls, the fixed part of cost stays the same, so margins fall faster than revenue. Operating margins from FY1 to FY5 were 12%, 14%, 16%, about 11% and 14%. Operating profit was 68 in the peak year, FY3, and 40 in FY4. That is a fall of about 41% on a 15% fall in revenue.
This effect is called operating leverage: fixed costs make profit swing more than revenue. It also explains why cyclical companies look cheapest at the peak of their earnings. Module 9 comes back to this 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", showed which adjustments are fair and which are not. Use that here. Remove true one-offs, such as a property sale gain or an impairment, and keep recurring charges in. If a one-off was taxed, remove its tax effect as well.
Larkspur's property gain of 6 sits below operating profit. FY5 profit before tax is 56 + 6 - 4 = 58, with interest of 4. Tax is 10, about 17% of profit before tax, so net profit is 58 - 10 = 48. The property gain carried no tax, so underlying net profit is 48 - 6 = 42. That is an underlying net margin of 10.5%.
Compare years using the underlying figures. Reported net profit rose from 30 in FY4 to 48 in FY5, up 60%. Underlying net profit rose from 30 to 42, up about 40%, while revenue grew about 11%. When revenue grows, fixed costs work in the company's favour, and the underlying figure shows how much. Check every year of the history the same way, because a gain or impairment in any one year distorts the trend you will use to set the forecast.
Before you put your margins beside a competitor's, check which accounting standards each company uses. Singapore-incorporated companies listed on SGX report under SFRS(I) (Singapore Financial Reporting Standards (International)), which are identical to IFRS. So Larkspur's revenue, cost of sales and operating profit follow 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 from IFRS in places. Some SGX-listed companies incorporated outside Singapore use other standards. When the standards differ, check how each company treats leases, development costs and one-off items before you trust a gap in margins. Lesson 9.3, "Choose a peer group that is really comparable", covers the rest of peer comparison.
Where your company discloses a revenue split, set out repeating and one-off revenue as separate lines for each year. Now take five years of your own company's income statement and restate them with the one-offs removed, ready for the margin columns.
Rewrite five years of your company's income statement without the one-off items, and work out each margin.
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