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Financial Statement Analysis

Expenses

Expenses are the costs that a company has to pay in order to generate revenue from its daily business operations. Since we already covered 'Revenue' in our earlier section. Here we will focus on 'Expenses'.

 

There are many kinds of financial and non-financial expenses that a firm incurs owing to its business operations. Some of the most important ones are discussed below:

 

  • Cost of goods sold (COGS): Cost of goods sold are the direct expenses involved in the production of goods & services. It represents the costs of producing the goods or services sold. 

Direct Costs primarily include basic raw material expenses along with the direct labor costs used to produce the goods or services. It excludes indirect expenses such as distribution costs and sales force costs.

 

For example, the COGS for a steel maker would include the material costs of the minerals that go into making steel like iron ore, coking coal, etc. along with the labour costs used to make the steel. The cost of sending the steel to dealers and the cost of the labour used to sell the steel would be excluded.

 

Analysts deduct COGS from a company's sales revenue to calculate a profit metric known as gross profits. If the COGS, as a percentage of total sales, increases on a quarter-on-quarter basis, this signifies poor operating performance. It might also signify that the company is unable to undertake price hikes despite rising raw material costs.

 

COGS is also referred to as “cost of sales”. It is calculated as:

 

COGS = Opening Inventory + Purchases – Closing Inventory.

 

COGS, in general, shall be higher for the companies in Steel, Cement or Retail sectors and shall be almost negligible for the companies in the service sectors like IT and Telecom.

 

  • SG&A: SG&A (Selling, General & Administrative Expense) is the sum of all the direct and indirect selling expenses as well as all the general and administrative expenses of a company. These expenses include those of marketing, salaries, utility bills, technology expenses and other general costs associated with running a business. They are incurred as a part of day-to-day business operations.

Direct selling expenses are expenses that can be directly linked to the sale of a specific unit such as credit, warranty and advertising expenses. Indirect selling expenses are expenses which cannot be directly linked to the sale of a specific unit but which are proportionally allocated to all units sold during a certain period such as telephone, interest and postal charges. General and administrative expenses include salaries of non-sales personnel, rent, heat and lights.

 

SG&A will be higher for the companies in sectors which involve very high marketing expenses. This includes sectors like FMCG, Telecom, etc. and would be comparatively lower for sectors like Steel, Oil Refinery, etc.

 

High SG&A expenses can be a serious problem for almost any business. Examining this figure as a percentage of sales and comparing it to other companies in the same industry can give some idea of whether management is spending efficiently or wasting valuable cash flow in marketing & sales activities.

 

  • Research & Development Expenses: Research and development are one of the means by which business can experience future growth by developing new products or processes to improve and expand their operations.

A business incurs R&D expense with the intention of making a discovery that can either lead to the development of new products or procedures, or improvement of existing products or procedures. For example, R&D expenses for a Pharma company or for a computer software company could be with an intention to develop a new drug or software, however, for a television company could be with the intention to improve the quality of its old products.

 

There is a big difference between Research expense and Development expense which is often considered to be one. Research expense is incurred when a firm is spending on research to come up with new product or ideas while development expense is incurred when the firm develops that idea or the initial product into a financially and operationally viable production stream.

 

From sales we subtract COGS, SG&A and R&D expenses to reach a profit metric called EBITDA (Earnings before Interest, Taxation, Depreciation and Amortization).

 

EBITDA= Sales + Other Income - (COGS + SG&A + R&D)

 

  • Depreciation Expenses: Depreciation is a term used in accounting and finance to allocate the cost of a tangible asset over its life span of several years. In simple words we can say that depreciation is the reduction in the value of an asset due to usage, passage of time, wear and tear, technological outdating or obsolescence, depletion, inadequacy, rot, rust, decay or other such factors.

Depreciation is used in accounting to try to match the expense of an asset to the income that the asset helps the company earn. For example, if a company buys a piece of equipment for ₹1 million and expects it to have a useful life of ten years, it would be irrational to expense the total ₹1 million in a single year since the asset will provide the benefit for a period of ten years. Hence, the cost of the asset is appropriated into its entire usable lifetime. Every accounting year, the company shall charge ₹1,00,000 (assuming straight-line depreciation), which will be matched with the money that the equipment helps to make each year.

 

Depreciation is a non-cash expense; thus, it does not reduce the cash balance of a firm however, it helps in savings of the tax expense since the recording of depreciation will cause an expense to be recognized, thereby lowering stated profits on the income statement.

 

  • Amortization Expenses: Amortization is a term used in accounting and finance to spread the cost of an intangible asset over its lifespan. While amortization and depreciation are often used interchangeably, technically this is an incorrect practice because amortization refers to intangible assets and depreciation refers to tangible assets.

For example, if Reliance Industries purchases software for its operational usage for ₹1 million, every accounting year, the company will expense ₹1,00,000 (assuming straight line depreciation) as amortization expense for every year.

 

From EBITDA we subtract depreciation and amortization expenses and come to a profit metric called EBIT or operating profit. (Earnings before Interest and Taxes)

 

EBIT= EBITDA- Depreciation -Amortization expense

 

  • Interest & Tax Expenses: Interest expense is the total cost incurred by the company for using borrowed money. It is generally higher for companies in sectors requiring huge capital expenditure such as Real Estate, Capital Goods, Engineering, etc and is comparatively lower for service sector companies like IT, FMCG, Pharma, etc.

Tax expenses is the amount reported by a company on its income statement as a part of its direct tax payments to the government

 

The tax expense for the year typically includes the following two elements-

 

1) Current tax – It is the tax expense that is due for the current year

 

2) Deferred tax – Deferred tax arises due to the difference in income recognition between the tax laws and the company’s accounting methods.

 

From EBIT we subtract interest and tax expenses to arrive at the Net Profit.

 

Net Profit = EBIT- Interest -Taxes

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Units 5/14