Analytical Review 101 - Part XVI

A Circle has no End

Overall Summary on Analytical Review of Nestle's Financial Statements

If you look at this series of posts, you will have realized that we have spent a substantial amount of time analyzing the Nestle’s financial statements. Perhaps more importantly, it would have struck you that it’s a LOT OF WORK! Yes, it is. Then again, perhaps it would be wise to reflect on how much time it took for you to earn RM10K before deciding to invest in a company? It may have took you perhaps two or three months of your life to save this much money. Then why are you so eager to invest in shares without spending, say one or two days researching the company you intend to invest?

My overall perception of Nestle is that it is a sound company to invest in. Cash flows are managed well and it has an attractive dividend policy. However, due to its’ strong brand name and excellent cash flows, the share price of Nestle is too high compared to its’ earnings. It is an excellent blue chip share to invest in, as a hedge against inflation. You may ask me, so at what price should I decide to buy shares in this company?

My answer is simple: Reread my series of posts and look at the latest quarterly financial results of Nestle in the link below. Then, make up your own mind and you decide at what price it is worth investing!

http://www.klse.com.my/website/bm/listed_companies/company_announcements/announcements/index.jsp

An End of a Long Journey
We have journeyed long through this Analytical Review 101 series. For those of you that have been diligently reading it, this series of posts may raise more questions than answers. Trust me, this is a good thing. The world of investing is fraught with perils and dangers. A little knowledge is a dangerous thing. I hope though, I have highlighted the dangers such ventures to your attention. Forearmed with such knowledge, an intelligent investor may yet profit from his investments.

For those readers that are interested in downloading Nestle (Malaysia) Berhad’s 2007 Annual Report, you can find it via the link below.

http://www.klse.com.my/website/bm/listed_companies/company_announcements/annual_reports/index.jsp

If you that are interested in constructing your own financial dashboards, I will be sending out my Nestle Financial Dashboard and all the relevant workings in an excel file. If you wish to receive it, kindly subscribe for my blog via the Feedburner Email subscription on the upper-right hand side. Your email will not be divulged nor will you be spammed.

Alternatively, kindly drop a comment in my blog with your e-mail address so that I can send the spreadsheet to you. I’ll be sending out the worksheet on the 30 August 2008 to all my subscribers or interested commentators.

A New Beginning
A circle has no end! Similarly, there is no end to our journey in the world of investing. One must learn, unlearn and re-learn about the stock market and our opinions of the companies we invest in. In my future posts, we will look at the more advanced aspects of investing. We will also look at the more noteworthy companies in Bursa Malaysia and perform detailed financial analysis to evaluate whether they are worth investing.

Two Intriguing Questions?
It is surprising to me that none of my readers have yet to pose me these two rather intriguing question. Some of you know me well, though for others, I am a totally anonymous figure. I do not wish to disclose my identity merely because I wish to remain low profile. However, if I were a reader, I would surely ask the blog author this:

‘Why should I listen to you?’
I ask you not to listen to me. Rather, I ask you to merely listen to what I have to say. As with all things, it is your judgment and discernment that will serve you best. If you agree with what I say, then act accordingly. Otherwise, let it pass. Comment, if you have any doubts or questions and I shall endeavor to answer any questions you may have.

‘Why the PriceLess advice?’
At this time and age, if you do not raise such a question, I would indeed be worried. Truthfully, this blog serves as both a personal motivational and disciplinary tool to ensure that my journey into the world of investing is both well reasoned and carefully planned. I have gained much from those that were willing to share their knowledge and wisdom with me, so why should I be miserly with my own? Remember, what is valuable is sometimes free, but not all those who read can profit from it.

Feedback
I would appreciate if you could revert with any comments or feedback you may have on this series of posts. Further, if you wish to me to explore certain investing topics in greater detail, please do let me know.

Analytical Review 101 - Part XV

An Investor’s Dilemma: Choosing between Mother Theresa & Angelina Jolie

Before one decides to invest in the share market, try answering the following question:

‘If you won a contest and could go out on a date with either Mother Theresa or Angelina Jolie, which one would you choose?’

[For ladies, try choosing between Gandhi and Brad Pitt]

If you ponder long and hard enough, it may be illuminating to realize that parallels can be drawn between the vastly different emotions Mother Theresa & Angelina Jolie evokes, and the world of investing.

Mother Theresa, founder of the Missionaries of Charity in Calcutta spent over forty five years of her life ministering to the poor, sick and dying while guiding the Missionaries's expansion throughout India and other countries. In 1979, she was awarded the Nobel Peace Prize for her work and contributions. Her very name evokes an idealism based on compassion, selflessness and loving kindness.

Angelina Jolie, conversely, has been cited as one of the most beautiful woman in the world. She is an acclaimed actress and has won three Golden Globe Awards, two Screen Actor Guild Awards and an Academy Award. Mention her name, a sensual, sultry and sexy image comes to mind.

Have you answered the question yet? If so, please read on…

Fixed Deposits are equivalent to Mother Theresa

In the world of investment, Fixed Deposits are equivalent to Mother Theresa. Both are stable, secure and strong. Why do I say that? This is because Fixed Deposits exhibits the following characteristics:

1. Principal Guaranteed
The principal that you invest is virtually secure. There are veryminimal risks involved when you put your money in Fixed Deposits. If you invest in RM10K in an FD, rest assured that one year later, you SHALL see that RM10K still in the bank.

2. Returns Guaranteed & LOW
When placing a FD for a period of time, the interest income receivable is stated up front. True, the returns are paltry. Yet, the great thing is that they are GUARANTEED. There are no IFs, ANDs or BUTs… It’s a sure thing, PERIOD!

3. High Liquidity
If you ever need cash urgently, there are no problems whatsoever in withdrawing out your principal even though it’s being placed in FD. In a worst case scenario, you may have to forfeit a certain portion of your earned interest income.

Angelina Jolie and the Sexy World of Shares
Everybody wants to get on the bandwagon these days and invest in shares! Who doesn’t drool over a hot looking sexy babe? Same thing with shares, just dump your money and watch it fluctuate…One day it’s up, the next it’s down. Just be careful and don’t get yourself burnt! Investments in shares are risky and I’ll explain why:

1. Principal Guaranteed to Fluctuate
When you invest in the shares of a company, you must understand that the only thing that is certain is your investment SHALL fluctuate! Once you dump in RM10K, a month later, it may grow to RM15K or shrink to RM5K. If you are the type of person who cannot live with any risk, then don’t invest in shares.

2. Returns Guaranteed to Fluctuate
Returns in the form of dividend payout by companies are also uncertain. Usually the discretion whether to pay dividends (and the quantum) or otherwise, lies solely with the company. As minority shareholders, one does not have much leverage to request for dividends. So, unlike FDs, don’t be surprised if you don’t get a single sen out of your investment until you sell it.

3. Highly Liquid IF YOU ARE DETACHED
Yes, shares are highly liquid. Unfortunately for you, if the RM10K you invested shrunken to RM5K, are you willing to sell it off? That’s a 50% loss on your capital! Conversely, if the stock market is booming and your RM10K has ballooned to RM20K, are you willing to cash out and let go of your shares? Or are you going to hold on and hope it goes up further…???

Analytical Review
With this in mind, let’s look at the Financial Dashboard below. As discussed above, we can compare FDs to Shares although there are vast differences:

FD Interest Income = Earnings
The FD Interest Income is a certain and guaranteed. However, earnings for companies are susceptible to competition, economy and a host of other factors. Interest rates are certain and are computed in advance during FD placement, whereas the current earnings of a company is largely uncertain at the time of investment.

FD Principal = Share Price
The Principal that you invest in FD does not fluctuate. However, share prices fluctuate daily depending on the mood of Mr. Market and the global economy.

FD Interest Rate = Earning/Market Price %
Whilst the FD Interest Rate is a sure thing, historical Earnings/Market Price % is not always, a reliable indicator of future returns. Firstly, we are never sure of the earnings at the time of investing. as we are relying on historical information. Secondly, the market price fluctuates daily making it difficult to quantify the probable return we can make on our investment. Depending on the competition and economic situation, a profitable company in the past may turn out to be unprofitable in the future. This is a risk for all businesses and as investors, we have to bear with it.

With this in mind, let us look at Nestle’s Earnings/Market Price %. It is hovering around 4.5 % to 4.8% for the past three years. As Nestle is in a stable industry with a strong brand name, this appears reasonable. Yet, FD rates are approximately 3.7% per annum, Nestle only offers an additional return of 1%. Is it really worthwhile investing? Although there is an upside in terms of capital appreciation (i.e. share price goes UP!), perhaps one should consider whether there are other companies yielding a higher rate of return.

Conclusion:
It is important to note that investment in shares is like dating a hot babe! Yes, it’s alluring at first sight, but exercise wisdom and caution, and hopefully you’ll avoid getting burnt. So, look before you leap!

Analytical Review 101 – Part XIV

Money Talks, Bullshit Walks: You and Mr. Market

Ultimately, as Intelligent Investors, we are only concerned about one thing. What is the value of the shares we are buying, truly worth? Based on our analysis, if we feel the company is worth between a range of RM30-35 per share and it is currently trading at RM25, then it worthwhile to purchase the shares in the company. Eventually, the market will price the Company's shares according to its’ underlying value.

Consequently, before investing, it is important to carry out an analysis backed up by financial data, rather than relying on speculation and market rumors. In future posts, we shall see how to use these historical data in conjunction with the market data to assess whether investing in a company is worthwhile.

Sources of Market Data
The Business Week website gives you free access to the market price and volumes traded, of major companies’. Most of the market price and trading volume, of major listed companies are free available on the Internet, so just Google for such information.

The link to view the share price of Nestle is here:
http://investing.businessweek.com/research/stocks/charts/charts.asp?symbol=NESM.KL

The Real Deal: Share Price
Up to now, we have been analyzing historical information based on the annual audited financial statements. Such historical information furnishes us the track record of management's ability to generate returns for its’ investors. However, we are missing a vital link: the Share Price!

The Share Price of a Company on a particular day represents the last transacted price between a willing buyer and willing seller. For an Intelligent Investor, the Share Price of a company DOES NOT represents the worth of a Company.

WHAT! WHAT [insert expletive here] ARE YOU TALKING ABOUT?

Mr. Market
Well, the reason is very simple. Markets are IRRATIONAL! I shall let Warren Buffett explain further on this concept. This is extracted from one of his letters to the shareholders of Berkshire Hathaway.

Ben Graham
Ben Graham taught me that the key to successful investing was the purchase of shares in good businesses when market prices were at a large discount from underlying business values. The true investor welcomes volatility. Ben Graham explained this in Chapter 8 of The Intelligent Investor. There he introduced "Mr. Market," an obliging fellow who shows up every day to either buy from you or sell to you, whichever you wish. The more manic-depressive this chap is, the greater the opportunities available to the investor. That's true because a wildly fluctuating market means that irrationally low prices will periodically be attached to solid businesses. It is impossible to see how the availability of such prices can be thought of as increasing the hazards for an investor who is totally free to either ignore the market or exploit its folly.

Ben Graham told a story 40 years ago that illustrates why investment professionals behave as they do: An oil prospector, moving to his heavenly reward, was met by St. Peter with bad news. “You’re qualified for residence”, said St. Peter, “but, as you can see, the compound reserved for oil men is packed. There’s no way to squeeze you in.” After thinking a moment, the prospector asked if he might say just four words to the present occupants. That seemed harmless to St. Peter, so the prospector cupped his hands and yelled, “Oil discovered in hell.” Immediately the gate to the compound opened and all of the oil men marched out to head for the nether regions. Impressed, St. Peter invited the prospector to move in and make himself comfortable. The prospector paused. “No,” he said, “I think I’ll go along with the rest of the boys. There might be some truth to that rumor after all.”

The Risk
Sometimes, the share price of a company (say ZGL) appears to be trading at a large discount from their underlying values. In reality, say that this is not the case. Mr. Market has correctly priced the shares due to business risks and other factors that you had overlooked. Here, you may have bought the shares at RM25 as your (erroneous) analysis, indicates that the underlying value should be around RM30-35 per share.

During this period, the share price of ZGL has plunged from RM25 to RM10 in the span of one year. Do you still keep your shares in ZGL in the belief that Mr. Market has incorrectly priced its’ shares? Or do you dump all your shares in ZGL and sell out?

As an Investor, you have to rely on something important called JUDGEMENT. Not even the world’s greatest investor, Warren Buffett is perfect. Expect to make some missteps, when joining the world of investing. The best thing to do is to set your tolerance level for losses. You may set a trigger point to sell ZGL shares, if it falls below a certain value. This is important as most of us are reluctant to admit when we have made a bad call. It is not easy to cut your losses but you must do so! Don’t throw good money after bad!

For instance, you could set your trigger point to sell ZGL shares if it falls by 40% from your initial purchase price (i.e. the market price of ZGL's shares drops to RM15 per share). Even though you have lost 40%, at least you preserved the remaining 60% of your capital. Obviously if the shares price shoots up to RM40 a year later, then the fact you were RIGHT, would be of cold comfort.

Conclusion:
We have looked at how to obtain the current share price of our target company. In addition, we have briefly explored the key investment strategy of an Intelligent (or Value) Investor. Please also keep in mind, Warren Buffett's illuminating explanation on the concept of Mr. Market, and how one can profit from market foibles and irrationalities . In my future posts, we shall use the share price of the company in conjunction with historical data, to assess the underlying value of a company.

Analytical Review 101 – Part XIII

SOLVENCY AND DEBT RATIOS'

It has been stressed that cash is of primary importance for a company. Without cash, the company would not be able to function, even if it is making substantial amount of paper profits. In order to measure whether the company has sufficient cash reserves or able to convert its’ assets into cash to meet its’ obligation, there are two financial terms that we must be conversant with.

Liquidity
Liquidity refers to the ability of the company to meet its’ short term obligations and commitments (i.e. those liabilities due within a year from the Balance Sheet date). The liquidity ratios discussed earlier, gives an indicator of the how relatively liquid a company is.

Solvency
Solvency is a gauge of the company’s ability to meet its’ long term liabilities (i.e. commitments exceeding a period of one year from the Balance Sheet date). The Debt Ratios' above are intended to reveal whether the Company is able to meet its’ long term liabilities in the long term. When we say a company is solvent, this means that the Company should be able to repay all its’ long term loans and borrowings and other commitments, in the future, usually due to its’ large assets base and ability to generate favorable operating cash flows.

Effective Interest ratio
We have computed the Effective Interest ratio in Part X. Briefly, the effective interest rate ratio gives an indication of the interest rates incurred by the Company on its’ loans and borrowings. Low interest rates on loans and borrowings, are beneficial to the shareholders as the shareholders will pocket the excess between:

1. The returns generated by the Company using these loans and borrowings; and
2. The interest costs associated to these loans and borrowings.

This concept is also referred to as gearing. There is an additional benefit in that, interest expenses are tax deductible and will reduce tax liabilities due to the Inland Revenue.

Operating Cash to Interest (OCI) ratio
The OCI ratio is crucial as it gauges whether the company can generate sufficient cash from its’ operations to service interest payments on its’ loans and borrowings.

An high OCI ratio (e.g. in excess of 10x) is favorable as this reveals the Company can service its’ debts with ease. If the OCI ratio is 1.5x or lower, its ability to meet interest expenses may be questionable. Once the OCI ratio falls below 1.0x, alarm bells should start ringing, since the Company's operating cash flows are insufficient to service interest payments. What about the repayment of the principal amount?

Debt Service Coverage (DSC) ratio
Whereas the OCI ratio compares the Operating Cash Flows to the Interest Costs, the DSC ratio compares the Net Profit for the Year against the Interest Costs. In effect, we are comparing the book profits against the interest expense. Generally, the higher the ratio, the more favorable it is. The general consensus is that the Company can service its’ interest costs and repay its' loans, if the ratio is 1.35x or more. However, this will vary from industry to industry and care must be taken when attempting to interpret this ratio.

Analytical Review
The effective interest ratio appears favorable to Nestlé as it is paying a very low interest of 4.82% (2006: 5.80%) on its’ loans and borrowings. The company’s abilities to obtain such favorable rates is partly due to its’ healthy operating cash flows and strong credit rating.

Analysis of the OCI ratio discloses that there has been deterioration in this ratio by 44.83% to 19.58x (2006: 35.49x). This is mainly due large amounts of cash tied up in inventories as at year end. However, a ratio of 19.58x indicates that that Nestlé should have no problems whatsoever, to service interest on its’ loans and borrowings.

A review of the DSC ratio indicates that this amount has also declined to 19.68x (2006: 26.19x). Still, this indicates that Nestlé is still highly profitable. The profits generated by the Company are more than sufficient (i.e. 20x) to repay interest expenses incurred. This is in line with the OCI ratio.

Conclusion:
Generally, Nestlé appears to be liquid and solvent. All indicators suggest that the Company has strong operating cash flows, sufficient to service its' interest costs. Despite the large loans and borrowings due in 2008, there are strong assurances that the Company would be able to refinance such loans and borrowings, for reasons outlined earlier.

Analytical Review 101 – Part XII

Day Payables Outstanding and the Cash Conversion Cycle

Day Payables Outstanding
In my earlier post, we discussed about the Trade Payables amounts. Trade Payables consists of amounts due to creditors and suppliers. It is noteworthy that the Trade Payables represents a source of financing to the company. Essentially, the company is purchasing goods or services from suppliers on credit, paying only after the credit period is due.

A indicator of the credit terms obtained by the company from its’ suppliers can be derived from the DPO ratio. Generally, this ratio indicates the length of time taken by the company to pay its’ trade payables. This ratio will vary from industry to industry. As such, it is more useful to compare this ratio over a period of time or against other companies’ in the same industry.

A high DPO ratio (e.g. in excess of 90 days) is considered favorable as the company is obtaining excellent credit terms and financing from its’ trade creditors. However, it is important to note the trend of the DPO ratio. If the Trade Payables amount and DPO ratio has increased significantly within a short period, it may indicate that the company is facing cash flow problems and is unable to pay its’ trade creditors on time. This can be corroborated by reviewing the cash flow statements and other liquidity ratios as discussed earlier.

Cash Conversion Cycle (CCC)
The CCC ratio attempts to quantify the time taken by the company to convert its’ inventories into cash, after accounting for the credit period (i.e. financing) provided by its’ trade creditors. The CCC ratio is significant as it indicates the efficiency of the company in converting inventories into cash. The lower the ratio, the faster the company is the rate of conversion of company’s inventories into cash. Conversely, a high ratio indicates that the company may be facing problems in collecting debts from its’ customers or have non-saleable stocks. This would contribute to the delay in converting its' inventories or receivables into cash.

This ratio will vary widely based on the industry the company is in. A company with a long gestation period such as construction companies’ will have a long CCC ratio whereas one in the FMCG industry should have a relatively low CCC ratio. Comparing this ratio over a period of time or companies in the same industry will provide a clearer picture of the effectiveness of management in generating operating cash flows.

Analytical Review
An investigation of Nestlé’s financial statements reveals that its’ DPO ratio is 49.46 days (2006: 42.68 days). This means that Nestlé has either obtained more favorable credit terms from its’ suppliers or is successful in delaying payments to its’ trade creditors. This modest increase of 15.9%, divulges the fact that Nestlé may be delaying payment to its’ trade creditors’ as most of its' cash are tied up in its’ inventories. A review of its’ operating cash flows discloses that the company is on sound financial footing and does not have problems in paying its’ trade creditors on time, if necessary. Overall the DPO ratio is generally favorable.

The CCC ratio has increased by 11.3% from 45.28 days in 2006 to 50.41 days currently. This increase indicates that Nestlé's efficiency in converting its’ inventories into cash, has decreased. Further investigation exposes the fact that there is a disproportionate increase in inventories (35%) compared to the increase in revenue (4.29%). This is the main contributor to the increase in the CCC ratio and the reduction in operating cash flows by 18.82% to RM291MIL compared to RM358MIL in 2006.

Conclusion:
The DPO and CCC ratio reveals that Nestlé is less efficient in converting its’ inventories into cash. Still, the CCC ratio and operating cash flows are still reasonable, even though it is less impressive, when compared to 2006. We have completed our review of the liquidity ratios and cash flow movements of the company. Next, we shall look at the Debt Ratios and Nestlé's solvency.

Analytical Review 101 – Part XI

LIQUIDITY– CURRENT AND QUICK RATIOS'

Earlier on, we reviewed the Current Assets and Liabilities section of the Balance Sheet in detail.

Current Assets are generally cash or assets that the company should be able to convert into cash within the period of one year.

Similarly, Current Liabilities are obligations or commitments that must be settled by the company within a year.

As Current Assets and Current Liabilities are assets and liabilities, receivable or due within a period of one year respectively, it is appropriate to compare these two amounts as an indicator of the company’s liquidity.

Current Ratio
The current ratio (as computed above), compares the current assets of a company against its’ liabilities. Generally, the higher the ratio, the more liquid the company is. If the current ratio is equal to 2.0x or more, the company is considered generally liquid, i.e. it should not have problems in meeting its’ short term obligations. If this ratio is less than 1.0x, then the company may have troubles to meet its' short term commitments. However, these are mere guidelines. The ratio may vary from industry to industry and care must be taken when interpreting this ratio.

Even when the current ratio is 2.0x or higher, it is important to analyze the components of the current assets. If the trade receivables or inventories are abnormally large, compared to previous years, then the DSO or Inventory Turn ratios' may raise alarms concerning the recoverability of the trade receivables or possibility of overstocking, respectively. If this is the case, although the current ratio is favorable, the company may still face liquidity issues due to problems in collecting debts or selling its’ inventories.

Quick Ratio
Generally, current assets indicate cash balances and those assets that are easily convertible to cash within a span of one year. If one wishes to be conservative, it may be better to exclude inventories from the current assets. This is because inventories may not be easily saleable, especially during a difficult economic climate.

The quick ratio compares HIGHLY LIQUID CURRENT ASSETS (i.e. Current Assets excluding Inventories) to the current liabilities. By and large, a ratio of 1.0x or higher, signifies that the company has good liquidity. This is because it can convert its’ HIGHLY LIQUID CURRENT ASSETS into cash to meet its’ short term commitments and obligations. Conversely, a quick ratio of less than 1.0x, indicates that the company may have issues in fulfilling its’ short term obligations. Take note that the figures are merely for guidance and may vary from industry to industry. Exercise care when interpreting the quick and current ratios.

Even if the quick ratio is 1.0x or higher, liquidity problems could still arise. If the company is facing troubles collecting amounts due from its customers, it will be reflected in large trade receivables balance and DSO ratio. In such a case, a quick ratio of 1.0x or more, may be meaningless as the company is unable to convert its’ trade receivables into cash to pay its’ short term commitments.

Analytical Review
An analysis of Nestlé’s Current Ratio indicates it is hovering around 1.08x (2006: 1.20X). This lower current ratio is mainly due to the large amounts of loans and borrowings due within one year from the Balance Sheet date of 31 December 2007. This signifies that if Nestlé can convert all these current assets to cash, it would be able to repay all its’ commitments. Generally this is acceptable, especially considering that the banks would have no problems in refinancing these loans and borrowings due to Nestlé’s strong operating cash flows.

The Quick Ratio of 0.57x (2006:0.71x) implies that most of the company’s current assets are inventories. However, as Nestlé’s is in the Fast Moving Consumer Goods (FMCG) industry, it should have little problems in selling its’ inventories and converting these into cash. The lower ratio is not worrying as an analysis of the DSO and Inventory Turn ratio suggests that trade receivables are still being collecting promptly and there is only a moderate decrease in the turnover of inventories. Overall, operating cash flows are still significantly large to enable Nestlé to meet its’ short term commitments.

Conclusion:
The Current and Quick Ratios' are convenient ratios to gauge the liquidity of a company. However, always keep in mind that a Current Ratio and Quick Ratio value of 2.0x and 1.0x respectively, does not necessarily mean the company is liquid. Further analysis of the DSO and Inventory Turn Ratio is required. This is to ensure that the favorable Current and Quick Ratios' are not due to mounting Trade Receivables and Inventories, arising from debt collection problems or non-saleable stocks.

Analytical Review 101 – Part X

LOANS AND BORROWINGS

Financing Company's Operations
To set-up a company, the shareholders need to initially pump in cash to finance the operations of the company. This is usually represented by the share capital.

Why Borrow?
Even though the operations of the company may be highly profitable, sometimes the shareholders are unable to expand as they have insufficient cash to finance costly expansions such as building new factories or investing in more sophisticated machineries or R&D. To finance such expansions, companies often borrow from banks or leasing companies.

Loans
Borrowings from banks usually come in the form of loans. If the company is small one, some form of security is required, either on the assets of the company such as land & buildings or personal guarantees from directors of the company. For large companies with excellent credit ratings, the banks may offer an unsecured loan.

Finance Lease Liabilities
Financing from leasing companies are in the form of purchase of large assets such as plant and machineries. The leasing companies will pay the suppliers of such machineries. The company will then undertake to pay the leasing companies a fixed monthly lease payment over a period of time. The total monthly lease payments will exceed the purchase price of the plant and machineries. These lease commitments are recognized in the Balance Sheet as Finance Lease Liabilities.

Operating Cash Flows
Banks and leasing companies are not charities. They expect the company to repay the monthly installment payments comprising of the principal and interest on a timely basis. A company that has loans and borrowings, must generate sufficient positive operating cash flows to finance the monthly installment payments. The Operating Cash to Loans and Borrowings Ratio (OCLB) indicates the financial ability of the company to repay such loans. A ratio higher than 1.5 is a positive indicator of the company’s abilities to service its’ loans and borrowings.

Interest Rates and Gearing
A benefit of loans and borrowings is that the interest’ rates charged by banks and leasing companies are usually lower than the profits generated by companies.

For example, if the company can generate profits of 15% on every Ringit invested in the Company, whereas the effective interest on loans is only approximately 5%, it may be desirable to borrow money to finance expansions. Why? Instead of raising additional share capital from its’ shareholders, the company can borrow from the banks instead. The banks are only entitled to a 5% return on its’ loans. The shareholders will be entitled to pocket the excess 10% difference (15% profit – 5% interest).

The effective interest rates on loans and borrowings can be computed as indicated above. When the company is generating a return that is substantially in excess of the effective interest rates, this is reasonably good as the shareholders will enjoy a higher return at the expense of the banks and leasing companies. Further, the interest payments to the banks or leasing companies are tax deductible, which will further reduce the company's tax expense.

In financial terms, this benefit is known as gearing or leverage.

The Dangers
Often companies tend to leverage their Balance Sheets excessively. Whilst using Other People’s Money (OPM) is an enticing idea, there are dangers if taken to the extreme. These include:

1. Downturn in economy or industry
When there is an unexpected downturn in the economy or the industry, the company’s operating cash flows will quickly dry up. Without sufficient operating cash flows, the company must resort to using its’ cash balances to repay the banks and leasing companies. If the company is unable to manage its’ cash flows well or refinance its’ loans, it may fail to service its’ debts. This may result in the banks or leasing companies foreclose on the loans and file a bankruptcy suit against the company.

2. Non-viable Business Model
If a company is perpetually refinancing its’ loans with and the quantum of loans and borrowings on its’ Balance Sheet is ballooning, this may indicate that the business model is not a viable one. Remember, a company’s PRIMARY PURPOSE is to generate PROFITS and convert them into CASH! When a company is unable to generate sufficient operating cash flows to repay its' loans and borrowings over the long term, you must ask yourself this:

IF NOT NOW (the company can't repay its' loans after a no. of years), THEN WHEN (can the company generate sufficient cash to do so)?

Analytical Review
A cursory review of the effective interest rates indicates that Nestlé is managing to keep its’ borrowings costs extremely low. An effective interest rate of only 4.70% (2006: 5.80%) is extremely favorable as the current FD rates per annum are approximately 3.70%. Further, all the borrowings of the company is unsecured which reflects the company has excellent credit ratings.

The OCLB ratio is 2.52x (2006: 1.35x) reflecting that Nestlé will have little trouble servicing its’ debts. Overall, with such strong operating cash flows, the burning question is WHY BORROW in the first place?

There may be two main reasons for this. Firstly, Nestlé wishes to leverage its’ Balance Sheets to generate higher returns for its’ shareholders. Secondly, it may be using these borrowings to maintain its’ aggressive dividend payout policy to maintain its’ share prices.

Even though RM308MIL of loans and borrowings are due in 2009, Nestlé strong operating cash flows and excellent credit rating, means the company will no problems in refinancing such loans.

Conclusion:
Despite having huge loans and borrowings of RM308MIL and amounts due to related companies of RM129MIL, Nestlé is financially stable. Its’ operating cash flows are sufficient to enable it to repay these borrowings in the long term.

Analytical Review 101 – Part IX

Balance Sheet – Current Liabilities

What is a Balance Sheet?
The Balance Sheet shows the position of the company as at the end of the financial year (or as at a specific date). The Balance Sheet contains summary information of all assets and liabilities of the company including its' Intangible Assets, Property, Plant and Equipment, Long Term and Current Assets, Long Term and Current Liabilities and the Shareholders’ Equity. This is noteworthy as it gives us an indicator as to the value or worth of a company.

What do Current Liabilities represent?
These are liabilities or obligations of the business that must be paid in cash within a period of one year. It usually consists of trade payables, other payables, loans and borrowings and taxation, that are due within a period of 12 months from the balance sheet date.

1. Trade Payables
Trade Payables consists of amounts due to creditors and suppliers. These amounts arise because most long term suppliers would give credit terms to the company. The average credit period given by the supplier would depend on, inter-alia, the relationship between the company and its’ suppliers and the type of goods sold or services rendered by its’ suppliers.

The longer the credit period given by the suppliers to the company, the larger the trade payables amounts recorded in the Balance Sheet. Why would suppliers grant credit periods to the company? Wouldn’t it be better for the suppliers impose Cash on Delivery (COD) terms on all purchases by the company?

Purchases by a company are usually on credit terms because most companies expect to be given credit terms as a gesture of trust and goodwill. Companies usually try to negotiate and obtain favorable credit terms from its’ long term suppliers so as to conserve its’ cash flows.

A sudden increase in trade payables of a company as compared to previous years, is not always favorable. True, the company is conserving its’ cash flows by paying its’ trade creditors later. However, this may be an indication that the company is facing cash flow problems and is UNABLE to pay its’ creditors on time. Another possibility is that the company’s operating cash flows may be used to pay off other more critical obligations such as repayment of loans to banks.

2. Other Payables
These usually consists of:
(a) Amounts due to related companies (trade and non-trade); and
(b) Other payables;
(c) Accrued Expenses.

By and large, this figure is stable and does not change significantly over the long run. It is usually not significant in the evaluation of the company’s value.

However, in Nestlé’s case, it is significant to note that the company owes its’ related companies approximately RM129MIL. Approximately 33.50% of these debts are trade related whereas the balances of 66.50% are non trade. A review of the cash balances of Nestlé’ reveals a balance of only RM31.6MIL. If these related companies were to require immediate repayment, the company would have insufficient cash to repay these obligations.

This further indicates that Nestlé may be pursuing an overly aggressive dividend payout policy and financing this partly through inter-company payables. Approximately 39% of these inter-company payables (i.e. RM50.15MIL) is a short-term loan denominated, in Japanese Yen and interest bearing at 3.72% per annum. The balances of RM78.85MIL are unsecured, repayable on demand and interest-free.

The above facts indicates Nestlé dividend policy may not be sustainable in the long run. The company must conserve its’ cash flows, if it is to repay its' mounting of debts and obligations. However, it is pleasing to note that the inter-company payables have been halved in 2007 as compared to 2006.

3. Loans and borrowings
For a company with such strong operating cash flows, it is disconcerting to note that the company’s short term loans and borrowings have ballooned almost fourfold in 2007. The company’s short term loans and borrowings is currently RM303MIL now, compared to only RM67MIL in 2006. This is a substantial amount and the company is unlikely to be able to repay this withing a period of one year, since it’s’ cash balances are only RM32MIL. It must refinance these loans. Further scrutiny is required on the loans and borrowings amounts.

4. Taxation
These usually represents amount of tax payable to the Malaysian Inland Revenue. It is generally not significant in our evaluation of the value of a company as it is largely out of the company's control.


Conclusion:
We have appraised and analyzed the major components of the current liabilities of Nestlé. The important components have been highlighted for further review, namely the inter-company payables and loans and borrowings. These will be looked in detail, in my future posts.

Analytical Review 101 – Part VIII

Inventory Turnover (Inventory Turn)

Always keep in mind that a company’s sole purpose is to generate profits and convert these profits into actual cash received. Therefore, a company with huge inventories, by itself, is meaningless. It is in the ability of the company to sell these inventories to its’ customers and convert them to actual CASH that is the crucial to the stability and profitability of a company. The Inventory Turn ratio is a key performance indicator of the company's ability to do so. The components of the Inventory Turn ratio are:

Cost of Goods Sold (COGS)
Cost of goods sold comprises of all direct costs attributable to the production of the goods sold by a company.

Inventories
Inventories usually consists of raw and packaging materials, work-in-progress, finished goods and spare parts.

Significance of the Inventory Turn ratio
The Inventory Turn ratio allows us to analyze how long it takes for the company to convert its’ inventories into sales to its' customers. This inventory turnover will vary widely based on the industry the company is in. A company selling large, highly customized machineries will have a longer inventory turn compared to one in the Fast Moving Consumer Goods (FMCG) industry.

It is more significant to compare a company’s inventory turn ratio over a period of time or compare the inventory turn of a company with other companies in a similar industry. A short inventory turn (e.g. less that 60 days) is a favorable indicator, as it means the company is holding just sufficient stocks to meet customer demands and less cash is tied up in inventories.

On the other hand, if a company’s inventory turn ratio has increased dramatically over time (e.g. to 120 days currently, from 60 days in prior years), this means the company may be facing problems. A high ratio may indicate that its’ inventories are non-saleable or is facing an overstocking situation. This leads to increase in insurance costs, warehousing costs to house the inventories and possibility of obsolete and damaged stocks. The company may face liquidity issues as too much of its’ operating cash are now tied up in the increasing pile of inventories in its’ warehouses.

Analytical Review
Nestlé’s inventory turn ratio indicates a significant deterioration of over 26.8% as compared to last year. Its current inventory turn is now 71 days as compared to 56 days in 2006. This indicates that Nestlé’ is unable to convert its’ inventories to sales as efficiently as in prior years.

Revenues have only increased by 4.29%, yet inventories have increased significantly by 35%. This disproportionate increase in inventories as compared to revenue is highlighted by the deterioration in the inventory turn ratio. A substantial amount of Nestlé’s cash is tied up in its inventories, reducing its operating cash inflow for the year. Management must review this situation closely to ensure that the inventory is managed to prevent an overstock situation.

Conclusion:
A high inventory turn ratio (especially compared to previous years or companies’ in a similar industry) is undesirable. This means that the company is unable to convert its’ stocks into sales to customers as efficiently as before. Consequently, additional insurance, warehousing and financing costs are incurred to maintain the higher level of inventories. Pay a close watch to the inventory turn ratio as it is a good key performance indicator of the Supply Chain Management function of a company.

Analytical Review 101 – Part VII

Day Sales Outstanding (DSO)

As reiterated (ad nauseam), CASH IS KING! To convert revenue into cash, one of the major areas a company must execute is to collect debts from its’ customers. This is represented by the DSO ratio, which is a key performance indicator (KPI) of the company’s credit control function. The DSO ratio is made up of two components, namely Trade Receivables and Revenue. Just to recap:

Trade Receivables
Trade Receivables consist of amounts due from customers. These amounts arise because most business gives credit period and limits to their customers. The average credit period given to customers vary depending on the industry they are in.

Revenue
Revenue represents sales to customers for goods sold or services rendered.

Significance of the DSO ratio
The DSO ratio is important is it indicates the amount of time the company requires to collect the debts from the customers. A very long DSO ratio (e.g. in excess of 90 days) would indicate that the company is facing credit collection problems or the recoverability of such trade receivables is in doubt. Whenever the DSO ratios balloons substantially in comparison with prior years, it is an indication that the company may have expanded too aggressively or relaxed its’ credit control procedures in an attempt to secure additional sales.

Conversely, an favorable DSO ratio (i.e. 30-60 days) usually indicates that the company is managing its’ credit control function effectively and are collecting all its’ debts promptly. Companies with low DSO ratios are usually well managed and should not face any cash flow problems. When considering whether to invest in the shares of a particular company, a low DSO ratio is a very favorable sign.

Analytical Review
A review of Nestlé DSO ratio indicates that it has been hovering around 29 to 32 days. This is extremely favorable. On average, Nestlé takes approximately about a month to collect debts from its customers after it’s’ products are delivered and sold to its’ customers.

This is however, not surprising as the bulk of it’s’ customers are likely to consist of reputable dealers, supermarket and hypermarket chains that have strong financial standing. Further, there is a lower risk of any huge exposure of bad debts as compared to companies in other riskier industries such as construction industry.

By converting its’ trade receivables to cash in such a short time frame, Nestlé is able to generate strong operating cash flows of approximately RM319MIL per annum to sustain its’ operations.

Conclusion:
Remember, PROFITS DOES NOT EQUAL CASH!

Always keep a lookout for the DSO ratio. If profits has increased substantially but DSO ratio has ballooned (e.g. exceeding 90 days from 30 days in prior years), all is not well in the company. Ultimately, in order for profits to be realized, the debts from customers must be collected. If debts from customers are not collectible (bad debts), then the increase in profits is meaningless!

Analytical Review 101 – Part VI

Balance Sheet – Current Assets

What is a Balance Sheet?
The Balance Sheet shows the position of the company as at the end of the financial year (or as at a specific date). The Balance Sheet contains summary information of all assets and liabilities of the company including its' Intangible Assets, Property, Plant and Equipment, Long Term and Current Assets, Long Term and Current Liabilities and the Shareholders’ Equity. This is noteworthy as it gives us an indicator as to the value or worth of a company.

What do Current Assets represent?
The Current Assets are assets which is expected to be sold or otherwise used up in the near future, usually within one year. It usually consists of trade receivables, other receivables, inventories and cash & cash equivalents.

1. Trade Receivables
Trade receivables consist of amounts due from customers. These amounts arise because most business gives credit period and limits to their customers. The average credit period given to customers vary depending on the industry they are in.

Usually, the longer the credit period given to customers, the larger trade receivables amounts recorded in the Balance Sheet. Why then should the company give credit periods to its' customers? Wouldn't it be better to have all sales on Cash On Delivery (COD) terms?

This is not possible for most businesses as it is often necessary to give reasonable credit period to customers for the company to secure sales and maintain customer goodwill.

A sudden increase in the trade receivables of a company compared to previous years is not always favorable. It may indicate that the company is relaxing it's credit period to customers’ to secure additional sales. Another possibility may be the company is facing difficulties in recovering the debts owed by its’ customers. Either way, this may result in the company facing cash flow problems, in the long run.

2. Other Receivables
Other receivables usually consist of:
(i) Other deposits, receivables and prepayments;
(ii) Amount due from related companies and subsidiaries; and
(iii) Loans to employees.

By and large, this figure is stable and does not change over the long run. It is usually not significant in our evaluation of the company's value.

However in Nestlé's case, is noteworthy that Nestlé has a long term loan to its' employees amounting to approximately RM22MIL. Note 9.2 states that “Loans to employees are unsecured, interest free and are not expected to be repayable within the next twelve months.”

Nestlé employees’ must be happy to enjoy such benefits. However, as a prospective investor, we would like to know what criteria is used to give out loans to it’s’ employees and what are the terms of repayment. If the RM22MIL cash was not loaned out to its' employees, and instead was placed in a Fixed Deposit with 4.5% return per annum, the company would earn an additional RM1MIL interest income.

3. Inventories
Inventories usually consists of raw and packaging materials, work-in-progress, finished goods and spare parts. Manufacturing and distribution groups like Nestlé must keep raw and packaging materials to convert them into finished goods such as ice-cream, powdered milk and drinks. Those raw materials that are still being processed into finished goods at the financial year end, will be classified as work-in-progress. Spare parts are consumables held, often for routine maintenance works and repairs of factory equipment.

Although inventories are assets of the company, it is important to examine this figure. When the inventories in the Balance Sheet is too high compared to previous years or to its’ cost of sales, this may indicates that the company is facing fierce competition and is unable to sell its’ inventories fast enough. Such a situation can easily lead to financial troubles. Large inventory balances may lead to additional warehousing rental, insurance premiums and risk of obsolete, damaged or non-saleable stocks. It is critical to ensure the company maintains stringent inventory management before making your investment decision.

4. Cash and cash equivalents
Cash and cash equivalents are cash, either in the bank or placed under fixed deposits with financial institutions. These are highly liquid instruments with minimal capital risk. Cash is critical to the survival of a company, so always keep a close watch on this balance.

Conclusion:
We have appraised and analyzed the major components of the current assets of Nestlé. Some of the important things to watch out for, when reviewing the components in the Current Assets have also been highlighted. My next post will look at the Current Liabilities section.

Analytical Review 101 – Part V

THE IMPORTANCE OF CASH FLOW STATEMENTS

Today, we will be reviewing one of the most fundamental components of the annual audited financial statements, namely the Cash Flow Statements.

What is Cash Flow Statements (CFS)?
Cash Flow Statements is a summary of the company’s cash inflows (funds coming in) and cash outflows (funds going out) for a period of one year (in the context of the annual audited financial statements). The CFS tracks the movement in the company’s cash and cash equivalents.

What does the Cash Flows from Operating Activities (Operating Cash Flows) tell me?
Simply put, the Operating Cash Flows are cash generated from the company during its’ ordinary course of business such as cash received from its’ customers less all operating cash outflows such as payments to trade creditors, employees, tax and money tied up in working capital (e.g. inventories and trade debtors).

The Operating Cash Flows indicates whether the company’s business is sustainable and is generating sufficient cash flows to fund its’ business. Unless the company is a new start-up or are involved in long term projects (such as construction companies’), operating cash flows should always be positive.

If the company has negative operating cash flows, you need to be very careful if you intend to invest in such companies. Why? Well, if the company cannot generate enough cash to fund its’ operations, how long do you think the company will last? More importantly, is the business sustainable in the long run?

What does the Cash Flows from Investing Activities (Investing Cash Flows) tell me?
For a company, it is not enough to generate a small positive Operating Cash Flows. It must generate sufficient positive Operating Cash Flows to finance its’ investing activities. In other words, the Company must have enough cash generated to finance enhancements to its' manufacturing capabilities & technologies. It must also have cash to purchase new property, plant and equipment to replace its’ existing factories, equipment and other fixed assets. Interest received from investments and proceeds from disposals of property, plant and equipment will also be classified under this category.

Generally, Operating Cash inflows must be sufficient to finance Investing Cash outflows. If it is insufficient over a period of time, the company must finance its’ investing activities through loans and bank borrowings. When this occurs, you must ask yourself, is the company incurring these loans for expansion purposes or merely replacing its’ current ageing assets.

If it is for the former purpose, the additional future revenues and operating cash flows arising from its' expansion should suffice to repay the loan and interest. However, if it is for the latter purpose, then further analysis is required. If a company cannot generate sufficient Operating Cash inflows to finance replacement of its’ property, plant and equipment, is the business really viable?

What does the Cash Flows from Financing Activities (Financing Cash Flows) tell me?
Financing cash inflows consists mainly of cash received by securing additional loans and bank borrowings. Cash outflows from financing activities usually consists of dividend payments to shareholders, repayment of borrowings &loans and payment of finance lease liabilities.

Commonly, Financing Cash Flows are usually cash outflows except when there are huge loans or bank borrowings secured for a particular year. The Financing Cash Flows indicates how much of cash is being utilised to fund the operations of the company. Over the long term, perhaps for a period of three to five years, the Operating Cash inflows must be large enough to cover both the Investing and Financing cash outflows. This will indicate that the company is a viable one and is in a position to repay its’ loans and borrowings over a period of time.

Overview
The sum of the Operating Cash Flows, Investing Cash Flows and Financing Cash Flows will indicate the increase or decrease in cash and cash equivalents for the year. This indicates how healthy the company is, in terms of cash flows. Healthy cash reserves are crucial for the stability and strength of a company. It would be desirable to review a company's CFS over a period of five years to analyze whether the company's business is viable.

Analytical Review
Please click on the picture above to see the Analytical Review comments.

Conclusion:
A detailed review of the Cash Flow Statements over a five year period is crucial in analyzing the financial health of a company you intend to invest in. Remember, in the long term, the company must have more CASH INFLOWS (cash coming in) than CASH OUTFLOWS (cash going out).

Analytical Review 101 – Part IV

Quality of Earnings Ratio

Let’s start with a quick quiz: What is the lifeblood of any business? [Highlight answer below]

CASH

Of all the figures in the financial statements, cash is the least susceptible to manipulation and creative accounting.

There are numerous techniques used to improve the cash flow position as at year end such as deferring payments to creditors, obtaining down payments from customers or aggressive debtors’ collection strategies. However, there is a limit to these techniques and Cash is still the most reliable gauge of the company’s overall performance.

The Quality of Earnings Ratio attempts to assess the quality of the Profit for the Year earned by the Company. In short, it assesses how much of the Profit for the Year has been successfully converted by the company into cash. Some of you might be scratching your head…

Remember this:
PROFIT FOR THE YEAR DOES NOT EQUATE TO CASH RECEIVED

Remember, in order to convert the profit earned into cash, a company must collect all the debts owed to it by the customers. Some of these debts may not be collectible, hence resulting in bad debts. Inventories held by the company may be subsequently damaged or expire, resulting in additional inventory provisions. There could also be some aggressive earnings management (i.e. creative accounting) by the company to boost profits which is not sustainable. Therefore, it is critical to look at the Quality of Earnings ratio to assess the quality of the profits indicated on its’ financial statements. Let us review the components of this ratio.

Profit for the Year
We have discussed what the Profit for the Year represents earlier. In principal, it represents the gain made by the company for the sales of its’ products less all costs incurred by the company.

Net Cash from Operating Activities
This component represents the cash generated by the company during the year from its’ normal operating activities excluding investing and financing activities. Generally, this amount indicates the cash received from customers, payments to creditors & employees, cash tied up in working capital and income tax payments. A well managed company should have a very strong operating cash flow. Otherwise, the company may run into liquidity problems later on.

Analytical Review
For a company like Nestlé, a strong operating cash flow is expected. Such an established company with excellent brands should get very favorable terms from its’ customers. Most of its’ customers, comprising of established dealers and hypermarkets chains would not have problems paying their debts on time.

A review of Nestlé Quality of Earnings Ratio indicates that this ratio has been hovering, on average, at 100%. This is a strong indication that in terms of cash flows, the company is doing very well in managing its’ working capital and converting profits into cash. Nestlé has been exceptional in the management of its' cash flows.

Conclusion:
Always check and review the quality of profits earned by the companies’ you plan to invest in. A strong Quality of Earnings Ration (close to 100%), indicates that the company is financially sound whereas a weak ratio (anything less than 80%) requires further detailed analysis of the divergence between profits and cash earned.

Analytical Review 101 – Part III

Profit Before Tax and Net Profit, Margins

How is Profit Before Tax arrived at?
If you look at Nestlé’s Income Statement; Profit Before Tax is arrived by using the Gross Profit less the following major items:

(a) Distribution and selling expenses
These expenses are mainly transportation costs incurred in delivering its’ products to its’ distributors & direct customers such as hypermarkets and dealers. Other selling costs consists of salespersons’ salaries, commissions, entertainment and other expenses. Advertising campaigns and product promotions expenses are also classified here.

(b) Administrative expenses
Costs incurred by back office departments such as Finance, Procurement, Credit Collection and Information Technology are usually lumped under these categories. Other fixed overheads (excluding factory overheads) will also be categorized here.

(c) Interest income
Interest income usually consists of interest earned on excess cash placed by the company in fixed deposits, short term money market deposits and other interest earning instruments.

(d) Interest costs
Interest costs consists of financing costs due to loans and borrowings secured by the company to finance its’ operations and capital expenditures.

How is the Tax Expense arrived at?
Tax expense consists of income tax liability payable by the company on its’ profits and deferred taxes. The income tax liability is largely out of the Company’s control, so it is of lesser importance in our analytical review.

How is the Profit After Tax arrived at?
Profit After Tax = Profit Before Tax – Tax Expense

Analytical Review
The Profit Before Tax (PBT) margin gives us an indication of the profit made by the Company from its' sales less ALL costs incurred including COGS and indirect costs such as selling, marketing, administration, financing and other costs.

An overview of the PBT margin of Nestlé from 2003 to 2007 indicates that its' margin has been hovering around 10% to 11% for the past four years. Overall, this figure is reasonably good as it means the company is making a profit of approximately RM0.11 for every Ringgit of sales made.

The Profit After Tax (PAT) margin signals the profit made after deducting the income tax payable to the Malaysian government. Review of the PAT margin for the past five years suggests that PAT margin is improving. However, this is largely due to tax incentives obtained as indicated in note 18 of the annual audited financial statements.

Conclusion:
A profit after tax of approximately 8% per annum is reasonable. However, it is not that impressive considering RISK FREE interest income from fixed deposits are approximately 3.70% whereas returns from EPF are about 5%. Please remember that Profit After Tax DOES NOT EQUAL TO Cash Earned as there is a timing difference in turning profits into cash (as indicated by the Quality of Earnings Ratio).

Further, there is always a moderate risk involved in investing in companies, even in one as established as Nestlé. As indicated earlier, comparison with Nestlé’s competitors’ PBT and PAT margins may give us a more complete picture as to the Nestlé's strength and weaknesses vis-à-vis the industry.

Analytical Review 101 – Part II

Gross Profit%
What does the Gross Profit % represent? To understand this, we need to understand two components, Revenue and Cost of Goods Sold.

Revenue

Revenue, turnover and sales all mean the same thing. It represents sales to customers for goods sold or services rendered. For a company like Nestlé, its’ revenues, inter-alia, are derived from the marketing and the sale, both locally and for export, of ice-cream, powdered milk and drinks, liquid milk and juices, instant coffee and other beverages, chocolate confectionery products, instant noodles, culinary products, cereals, yogurt and related products.

Cost of Goods Sold (COGS)
Cost of goods sold, COGS, or "cost of sales", comprises of all direct costs attributable to the production of the goods sold by a company.

This amount includes the materials cost used in creating the goods along with the direct labor costs used to produce the good, meaning only costs that are directly tied to the production of the products are classified under COGS.

For Nestlé, its’ COGS would include costs of raw materials purchased including transport costs to bring these materials to its’ factories. The factory workers’ wages and overheads to convert the raw material foodstuffs into saleable products’ would also form part of its’ COGS.

Gross Profit

Gross Profit = Revenue - COGS. Therefore, gross profit % represents the overall gain realized from the sale of its’ products. A gross profit % of 32.94% means that for each Ringgit of sales made, Nestlé earns RM0.32 sen. This means it only costs Nestlé RM0.68 to produce the product.

However, take note that the Company must cover its’ other costs not included in the COGS. These include indirect costs such as distribution & selling expenses, administrative expenses, other expenses, interest costs and tax expense.

Analytical Review

So what does else does the Gross Profit % tells us? Not much really. That is why we need to compare over a period of time. By constructing the financial dashboard, we can see the trend of the Gross Profit % over a period of five years, from 2003 to 2007.

Overall, we can see that Nestlé has been successful in maintaining its’ Gross Profit. This means that despite the increase in raw materials such as basic foodstuffs, the Company has managed to pass on these additional costs to its’ customers by raising its’ prices. It may also indicate that the factories of Nestlé are continuously improving its’ efficiency and processes and keeping operating costs down.

An even better comparison would be to compare Nestlé Gross Profit % with its’ competitors such as DUTCH LADY MILK INDUSTRIES BHD. We shall do this at a later date.

Conclusion:
By performing some basic computations, we know now that Nestlé appears to profitable as it is making approximately RM0.32 for every RM1 of sales. These profits appear sustainable as the Company has managed to maintain its’ Gross Profit % despite the rising costs of raw materials foodstuff.

Analytical Review 101 – Part I

Before we start, I would like to quote Steven Covey, from his book “The Seven Habits of Highly Effective People”:

BEGIN WITH THE END IN MIND!

So, you should ask yourself: What is the end product of my efforts to calculate these financial ratios and performing analytical reviews?

Well, it should look similar to the financial dashboard above!

In order to analyze and assess companies' quantitatively; we need to construct financial dashboards to make sense of all the information contained in the annual audited financial statements. We will be attempting to construct the above dashboard to help us assess whether the company is worth investing based on its’ current market share price.

The information contained in the financial dashboard above is based on the Annual Audited Financial Statements of Nestlé’ (Malaysia) Berhad, downloaded from the Bursa Malaysia website.

For those of you interested in learning about the construction of the financial dashboards and performing analytical reviews, kindly download the Annual Report for Nestlé’ (Malaysia) Berhad for the financial year ended 31 December 2003 to 2007. All the analytical reviews and financial ratios calculated will be based on Nestlé’s audited financial statements. The link to the Bursa Malaysia is available on my Investment Resources Link section.

Please go through the financial dashboard above carefully. I will be reviewing each financial ratios in detail, in my subsequent posts so that we can make sense of the information in the financial dashboard.