Cracking The Income Statement Code

Foreword from ShareInvestor

This article “Cracking The Income Statement Code” by Cai HaoXiang was first published in The Business Times on 21 Mar 2016 and is reproduced in this blog in its entirety.

In our previous column on March 14, we discussed the process of stock research. Today, we continue with a basic reading of the first financial statement investors tend to look at: the income statement.

The example we are using for this series is Yum Brands, the US-listed owner of KFC, Pizza Hut and Taco Bell. We start from the statement on Page 51 of Yum’s latest annual report, accessible from the US Securities and Exchange Commission’s Edgar database.

Numbers in the income statement can move stock prices because they show how well the company is making money for shareholders. The number that shareholders care about is known as net income or net profit. It is usually at the bottom of the income statement. Hence, another phrase for net income is the “bottom line”.

Net income is essentially revenue minus costs. It’s called “net” income because it is the income that remains – perhaps caught in the net – after everything else, such as raw materials, employee costs and taxes, is taken out.

Top To Bottom

Starting from the top, we see how Yum gets two sources of revenue. One is “company sales” (around US$11 billion) and the other, “franchise and license fees and income” (around US$2 billion).

Always try to understand where revenue comes from. Company sales refer to revenue from company-owned restaurants. These are outlets directly owned and operated by Yum, mostly in China.

But the bulk of the money that people pay for Pizza Hut meals and two-piece chicken KFC meals is not recorded in Yum’s statements. Rather, Yum’s growth is indirectly tracked under franchise and license fees and income.

Franchise income is lower but very significant. Franchising is a critical part of Yum’s business model and carries a higher profit margin.

What is franchising? It is the brand owner Yum authorising other business entities around the world to open mostly KFC or Pizza Hut restaurants. Franchisees, which are licensed to use Yum’s brand names, stump up their own money to set up the restaurant. They receive training from Yum such that they can uphold certain standards of consistency and quality. In return, franchisees contribute a portion of their sales as royalties.

The “revenue recognition” part of Yum’s notes on page 58 tells us that income from franchisees also include rental income, because some franchisees lease their restaurants from Yum. Franchisees also pay fees to renew their franchise.

Cost Structure

Moving on to costs, we can quickly calculate some ratios to get a sense of how the company-owned restaurants spend money as a proportion of their revenue.

Raw material (“food and paper”) make up 31 per cent of company restaurant costs; wages (“payroll and employee benefits”) make up 23 per cent, and rent and marketing (“occupancy and other operating expenses”) make up 30 per cent.

Moving on, general and administrative (G&A) expenses are known as “headquarters costs”. They include senior management salaries and other expenses not associated with day-to-day operations, along with pension costs and research-related spending. We learn from the notes on Page 58 that G&A expenses include internal costs incurred to support Yum’s franchise operations.

Meanwhile, direct costs associated with franchise operations are charged as franchise and license expenses. These include provisions for uncollectible fees, rental and depreciation costs for restaurants that are leased or subleased to franchisees, and franchisee marketing costs.

It is worth noting how franchise revenues can already cover G&A costs in addition to direct franchise costs.

Finally, closures and impairment expenses are not relatively big this year. But they have been significant in 2013 and 2014 due to the poor performance of a Chinese hotpot restaurant chain called Little Sheep, which Yum had announced plans to acquire in 2011. We will come back to this in our discussion of the balance sheet.

After starting with revenues and running through a list of costs and expenses, we are now at operating profit for the group. Divide that by total revenue and we have an operating margin of around 15 per cent.

That’s not bad at all, though rival chain McDonald’s has even more impressive numbers with a 2015 operating margin of 28 per cent. This is because its franchise operations are far more profitable.

Much smaller outfits will be happy with operating margins of around 10 per cent. For example, local chilli crab chain Jumbo Group clocks 12 per cent, Japan Foods is running at 8 per cent, while Soup Restaurant only makes 3 per cent.

Take away interest costs and provisions for income tax and we finally arrive at net income.

To sum up, one way which we can understand how easily a company makes money is through its income statement. There, we can see a snapshot of how expenses eat away at revenues. And we can understand, through calculating ratios known as profit margins, how efficiently a company makes its money.

These numbers only make sense when read in conjunction with other information in the annual report and other financial statements. We also have to compare with the company’s competitors. In future articles, we continue our examination of Yum.