Following The Trail Of Money

Foreword from ShareInvestor

This article “Following The Trail Of Money” by Cai Haoxiang was first published in The Business Times on 15 Sep 2014 and is reproduced in this blog in its entirety.

Marketing, administrative and finance expenses can yield insights, says CAI HAOXIANG

LAST week, we began analysing the Q3 2013 income statement of sports shoes and casual wear retailer Eratat Lifestyle.

That was the last income statement that it issued before it was suspended early this year for missing a bond interest payment, as well as problems in verifying its cash balances.

Just by analysing segmental revenues, cost of sales, average selling prices and gross profit margins, we could see signs of decline in the company’s core business.

However, these signs were hardly fatal to the business. The company was still making money, though not as much as before.

This week, we examine the rest of the income statement, especially the various expenses between gross profit and net profit.

The upshot: closer scrutiny of Eratat’s interest income and debt payments would have turned up some red flags.

Getting To Net Profit

One issue that can confuse investors reading the income statement for the first time is the numerous measures of profit.

In this case, we have gross profit, profit before income tax, profit for the period, and total comprehensive income.

Gross profit comes after deducting cost of sales from revenues.

This is the most basic measure of profit, indicating how much money the company is left with after deducting the cost of labour and raw materials that went into producing the goods, from the goods that were actually sold.

After gross profit comes a number of items.

The most important ones are selling and distribution expenses, and administrative expenses.

Selling and distribution expenses are costs linked to transporting a product from a factory to a retail outlet, storage costs, and advertisement and marketing costs such as the cost of promotion activities and salaries of sales staff.

Costs of attending trade shows and setting up promotional booths at events would fall under this category.

We can see that Eratat’s selling and distribution expenses for its third quarter ended Sept 30, 2013 fell by 21 per cent from about 20 million yuan (S$4.1 million) to 16 million yuan.

These expenses for the nine-month period fell even more – 44.5 per cent from 86.4 million yuan to 48 million yuan.

Falling expenses are usually good news for investors, because profit margins are higher if a company cuts costs.

But things are not necessarily as clear-cut. In this case, third-quarter selling and distribution expenses fell because of lower advertising expenses.

Sometimes, advertising and marketing costs have to be incurred in order to boost sales. Higher sales might then have kept a business going.

It is not unusual for this category of expenses to temporarily spike due to a new product launch.

Curiously, nine-month selling and distribution expenses fell dramatically “because there was no renovation subsidy incurred this year whereas there was a renovation subsidy of 41.8 million yuan incurred during the same period last year”.

What is a renovation subsidy? Hang on to the thought – we will deal with this in our next article.

Meanwhile, administrative expenses include salaries of office staff and senior executives, rent payable to landlords, stationery and postage costs.

You can find details on the salaries of senior executives in the annual report for the previous year.

For example, Eratat CEO Lin Jiancheng was paid S$500,000 to S$700,000 in 2012, and executive director Ye Sanzhi was paid S$250,000 to S$500,000. Chief financial officer Ho Ker Chern was paid S$200,000 to S$300,000.

Sometimes you can check if executives are paying themselves too much compared to the sales that a company is generating.

That does not appear to be the case here: Assume the pay of all the executives and directors named in the 2012 report were in the top end of the stated range, and compensation for the year works out to S$2.6 million, or roughly 13 million yuan.

Assuming that these costs are around three million yuan a quarter, these “headquarter expenses” amount to just one per cent of sales and about a fifth of administrative expenses.

Detour To Interest Income, Debt Payments

After these expenses, we have almost come to what is known as the “bottom line” of a firm, or net profit.

Before we get there, we have three items to add or subtract: other revenues and expenses, finance revenues and expenses, and taxes.

“Other income” and “other expenses” refer to miscellaneous revenues and expenses not related to the operation of the business.

These might include rent collected, one-off gains or losses from selling an asset, interest income from bank deposits, or realised foreign exchange gains or losses.

Interest income can also be reported separately under “finance income”.

This is what Eratat does. In 2012, the only item under finance income was “bank interest income” of 1.375 million yuan.

In the third quarter of 2013, finance income amounted to 466,000 yuan.

For the nine-month period, finance income was 1.34 million yuan – leading one to infer that interest on bank deposits is paid regularly instead of in one lump sum towards the end of the year.

Investors who want to check how much interest Eratat’s bank pays it could roughly divide interest income for the quarter by the previous quarter’s cash pile.

Cash at end-June 2013 was around 500 million yuan.

This does not include proceeds of about 100 million yuan from a bond issue in late June, to be received in July.

Dividing 466,000 yuan of interest income by 500 million yuan of cash in the bank works out to a three-month interest rate of 0.0932 per cent, or roughly an annual interest rate of 0.37 per cent.

Eratat usually keeps almost all its cash in the bank and a negligible amount on hand, according to its 2012 annual report.

Its bank is the Agricultural Bank of China (ABC). According to ABC’s 2013 annual report, interest rates paid out on demand deposits to corporate customers were 0.74 per cent. Time deposits for corporate customers paid out a 3.45 per cent interest.

Too Low Here, Too High There

It is thus strange that Eratat is getting a 0.37 per cent interest rate on its cash.

Also, the company’s reasonably large cash pile suggests that it could park some money in far higher-yielding time deposits, instead of purely in demand deposits.

These low interest rates are also seen when comparing interest income in 2012 with the end-2011 cash balance.

This would be something to clarify with company management.

Meanwhile, debt interest payments are also reported under “finance costs”.

Here, a standout item for the third quarter is Eratat’s 8.7 million yuan worth of finance costs.

Given that the company borrowed about 100 million yuan, Eratat is paying about 8.7 per cent of interest a quarter on those bonds, or almost 35 per cent a year.

This is unusual.

Go back further in Eratat’s announcements in 2013, and you will see that the company issued a 134 million yuan bond to a subsidiary of well-known Hong Kong finance firm Sun Hung Kai & Co, with an interest rate was 12.5 per cent a year, payable quarterly, for two years.

But the subscription price was only 100.5 million yuan.

This meant that Eratat borrowed 134 million yuan that it had to pay back not including interest, but only received 100.5 million yuan.

Essentially, Eratat will pay 134 million yuan x 12.5 per cent x 2 = 33.5 million yuan in interest, and an extra 134 – 100.5 = 33.5 million yuan when it repays the bond in two years’ time.

This works out to a 67 million yuan interest payment over two years for 100.5 million yuan of cash received – or a compounded 29 per cent a year in interest.

If the abnormally low bank interest rate that Eratat was receiving on its cash balances did not attract any attention, the abnormally high interest rate that it is charged for borrowing money should.

This issue is compounded by the fact that Eratat had 500 million yuan sitting in the bank, yielding close to nothing, before it borrowed 100 million yuan more.

On hindsight, these details, gleaned off the income statement, amount to serious issues that investors should wonder about.

Questioned by investors, the company said that Sun Hung Kai’s business network could open doors, and the company had no alternative but to tap on the extra cash to grow.

In the light of what happened subsequently, investors’ suspicions came true. The 500-plus million yuan balance in the bank turned out to be illusory.

Net Profit, Finally

We are finally near the bottom part of the income statement.

We had started with revenues, where the deduction of cost of sales leaves us with gross profit.

That was a rough measure of how much a company is making from selling its products after taking out raw material and labour costs.

We then deducted other administrative and marketing costs, and considered other items, including finance income and expenses.

We end up with profit before tax, a more accurate measure of whether a company made money in a period.

Profit before tax is usually presented separately from net profit because tax policies can vary between countries and over even different periods of time.

The investor will have a better idea of how the company performs by ignoring the effect of taxes.

Finally, take out income tax, and we get net profit, presented in the statements as “profit for the period”.

It was a long journey to get to this “bottom line”.

Net profit for Eratat’s third quarter in 2013 was down 31.3 per cent to 38.8 million yuan.

But net profit for its nine-month period was up 4.3 per cent to 101.5 million yuan. This looks better, but is it really?

Looking through the entire income statement, one would see that the lack of a 41.8 million yuan renovation subsidy expense in the first half of the year boosted profits.

We will discuss this in the next instalment of this series.