The income statement : Revenues – an important figure.

Sales or revenue is the value of all the products or services a company sold to it’s customers during a given period of time. Profits of the company are based largely on the volume of this  figure.

Why this figure is important.

More revenues means more profits. An increase in profits year on will have a positive impact in the stock price. So companies are always eager to show increased revenues in the profit and loss account. And, the ‘sales’ figure is one of the easiest figure to manipulate.

How do companies manipulate sales?

  • Method 1. Sales to related parties – The Company may sell its products to another company which may be owned by a director or any one who has substantial influence in the company.
  • Method 2. Record fraudulent sales using fake bills. For example – It was discovered that Mr. Raju of satyam computers created as many as 7,561 fake invoices during the period from April 2003 to December 2008.
  • Method 3. Very Flexible terms for payment for the buyer – by providing such a facility the company may boost up the revenues temporarily, but in the long run such arrangements  pose an increased risk of the payment never being realized!
  • Method 4. Including one time revenues like income from sale of fixed assets like unwanted machinery or scraped assets or even loan amount received in the sales figure and thus boosting the figure and profits.
  • Method 5. Companies can adjust reported net earnings simply by changing accounting policies. These tend to be quite complex and difficult to understand, but the details are going to be found in the footnotes. For example, a company may change the way it values inventory, which in turn could have a big effect on calculation of the cost of goods sold and gross profit.
  • Method 6. Converting reserve profits to income. This may also be difficult to understand for a newbie. Reserves are profits earned in the past years, kept aside for future expansion activities. Companies carrying large balance in reserves can manipulate current year outcome by simply reclassifying all or part of the reserve balance to income.

Well, i am not here to list out fraudulent practices…. that list goes on and on from least complex ones to complicated accounting tricks. The question is how to analyse a company’s quality of revenues.

HERE’S YOUR SIX POINT CHECKLIST.

  • How can a company continue to earn profits year after year? By selling more and more every year. So, the first question to be answered is – Does the company have a history of increasing revenues every year?
  • Now the second question to be answered is – Are the Revenues increasing at par or above the other competitors in the industry?
  • Does the company have a unique product-line that will sell fast? You have to invest in companies whose products and business model you understand.
  • Does the company have a unique branded product to sell? Branded products are easy to sell and if consumers love the brand, they do not mind paying a premium for its products & services. For example – Maruti. Moreover, a company with a brand value can easily diversity into other sectors and instantly become successful – For example Titan. They have diversified successfully into the eye wear and diamond jewelry sectors.
  • Take the current assets section in the balance sheet. The amount of unrealized sale from customers will be given under the head “accounts receivables” or “sundry debtors”. Check if the receivables are showing a sudden jump. Co-relate with the revenue figure and see that the revenues and receivables are growing at the same pace. For example – if you see the revenues growing moderately but receivables showing a sudden jump, that’s a red flag! You need to be careful. You have to look for company’s disclosures regarding related party transactions, sale to sister concerns , change in the assessment of customer’s ability to pay , extended payment terms offered to any particular client etc..
  • Calculate the price /sales ratio. Calculating the price/sales ratio is a simple matter of performing the maths. Let’s assume that the company we are using as an example had revenue of 300 million rupees over the last four quarters. If we take the current market capitalization of 150 million rupees and divide it by the revenue of 300 million rupees, we arrive at a P/S ratio of 0.5. As with the P/E ratio, the lower this ratio is, the better the odds that this will prove to be a good investment.

    You may like these posts:

    1. The income statement : Difference between earnings and revenues
    2. The Income statement: Understanding the components.
    3. The Income statement : Basics

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