Making sense of financial statements. June 30, 2023

31:27We're going to do this. The trouble is that the fixed costs keep growing and growing and growing. What's a good example? Dubber, I think, is a good example. They've got software that does sort of call recording services, et cetera, et cetera. Their revenue growth has been insane. It's like you wouldn't believe it. It's phenomenal. This is a staircase, bottom left, top right. It's just a thing of beauty. But each year their fixed costs get bigger and bigger and bigger and bigger. And they never unlock that much sort of touted operating leverage. So you've got to be careful not just to assume that they'll be able to do it.

31:59And you've also got to be realistic that at a point you will need to grow your fixed costs. You know, there's a certain level of sales that your fixed costs can handle. And that might be much higher than what it is today. But at a point, you do need to hire more people because it's bigger and bigger and bigger operation. Amazon cannot run on a staff of 30. Like, you just can't, right? So, you know, you will need to sort of assume some growth. And it's prudent, in fact, to have increased costs, really, because you might find that you're unable to do a proper service delivery without the proper costs.

32:32And people will get fed up and the sales growth will disappear. here but yes i i just i love i love operating leverage when it's realized yeah i love it i i there's another kind of somewhere in between there mate is it's kind of a there's a sawtooth uh opportunity to for for expenses and for profits and the best way to think about this is let's say you're running a i'll say a steel mill they're not particularly attractive businesses but here's the thing when you when you spend i mean i don't know what the numbers are let's say you spend 50 million dollars building a steel mill right on day one you said the 50 million dollars you're making nothing that is just an absolute white elephant yeah now as you as you grow your volume you put your first roll of steel through i'm going to lose myself very quickly i'm not a steel mill expert um you you know you you build your build your first widget you output your first piece of piece of finished product and all of a sudden you start to make a bit of money back to cover that cost and then you keep going keep going and keep at some point you get to a break even and then after that point you actually start to make a whole lot of money and when the factory is 100 capacity you are making as much money as you're ever going to make out of that factory because you've got the machines working full time the the money you're making the profit you're making from those sales are just covering all your costs and spurting a whole lot of money and you make 100 widgets a year because that's as many widgets you can make in the steel mill yeah i'm reliably informed edward that widgets aren't made of steel but for now we're going to assume they are and then and then you get the 101st order and you kind of go well bugger i i can't actually fill that order i've i don't have a mass capacity and so eventually you say well i've got another one hundred two dollars hundred two orders and eventually the boss says all right guys tiny build a second steel mill let's do it the second you do that your profit plummets goes through the floor why because you had a whole lot of cash now we're ignoring the fact we'd capitalized some of this i was gonna say there's a wrinkle here but Yeah, you're right.

34:27Thank you. You outlaw a whole lot of cash and you make one more widget. It's all of a sudden you go from this obscenely profitable business to a moderately profitable business because you're making a fortune on the first factory. The second one is an absolute sinkhole. Yeah. But then again, you start to build that out. You build three, then four, then five, and you get back to 180. Now all of a sudden you're making money again. And when they're both at capacity, you're making twice as much money as you were previously, maybe even a little bit more than that because you've only got one CEO and one CFO and one brand and one marketing campaign.

34:55And so you can get this up and down when you're building out scale, adding more volume can actually cost you more money, or not cost you money, you're making less money, you can grow sales and actually have reduced profits. And you think, well, who on earth would do that? And the answer, hopefully, if the investment is sound, is it's a transitory experience while you get that new facility or new product or a new office or a new territory or something up to scale. Zero did this. Actually, a better one is um neemap is it i think it's still listed i'm not sure if it's still listed neemap had this great australian they basically took photos out of planes and then stitched them all together using software and the australian business was really profitable and they went hey what we should do we should go to america we're going to try and take over that market and you can imagine the population is 15 times the size the land mass is not all that much bigger but there's many many many more urban areas so you needed more photography and more software more developers.

35:53And so they had this business that looked on the surface really kind of just only barely profitable. They're making a squillion dollars in Australia, not literally, but they were spending it all trying to grow this US business. Now, if it's worthwhile spending, as a long-term investor, if they can make that work, this business will be much, much, much more profitable in five or 10 years time. But right now, you look at it and go, this is an awful business, not making any money. This is terrible. Now, if you're a long-term investor and you believe in the company's vision and mission and they can the execution frankly they think they can do it then it's a great opportunity to Andrew's point of that you know that that is the business to 100 million dollars of sales earning no profit that was affected with an EMAP story now even when they grow the U.S.

36:35business then the profit comes in then they start covering their costs and then it rains cash and so that's an example of just that sawtooth pattern where to get to where you're going you've got to take some losses in the short term to allow that scale to play out. I'll give you another example, which I've got some shares in and not much now for various reasons, but Nanisonics company, they make this nano nebulant sterilization device for ultrasound probes. So I used to sort of get some ethanol and wipe it down and did a pretty good job, but there's problems with that. You just chuck it in this machine, it sterilizes it for you, audits.

37:12It was a really, really cool kind of product. But they've spent a lot of money, a lot of money, in trying to develop a new product for, I think, endoscopes and other sort of medical thing. Now, that masked the profit. If they had not bothered with that, and this is still early days, so I don't want to sort of count chickens here before they've hatched, their profitability would have just been insane, like just incredible. But they said, no, let's make less profit. um well let's make less profit now and and we'll do that because we'll make more profit in the longer term i think there's good potential for that to happen so it really does whether it's a geographic expansion whether it's a product expansion the old adage is true you must spend money to make money and so the real question here is it's got to stop we we ranted about this when we're talking about the budget there are costs and there are investments and they're different right?

38:08One is just an outright cost. I'm not getting anything back that is something I've got to pay. The investment, I'm outlaying money. Yeah, true. But I expect something to come back as a result of that. And so while it's tempting to say, oh, you should just do this and then you'll make much more money. It's like, yeah, but you could be leaving a lot more money on the table and maybe there's other competitors out there that will be spending money on R &D or will be moving into new geographies and will be able to, in the future, make much more money. You mentioned zero before. Now, what a reaction that's had recently on the market because, again, their top line has just been growing incredibly.

38:45But their profitability was massively dampened by, let's face it, a few bad acquisitions. It wasn't the best capital management there. But also a lot of money spent trying to break into America. Now, in Australia and New Zealand, to some extent, the UK, they've had a lot better success. The UK is dominated by QuickBooks. Intuit is the company there and that's a much harder that is a much much much more difficult thing now are they everyone's everyone's sort of a hindsight expert here um but but you kind of it's i'm i'm pretty forgiving of companies that that try it when it's a reasonable proposition nothing in life is guaranteed and certainly nothing is guaranteed in business i don't think that's the mistake even if it ends up failing i think the mistake is is where you you bury your head in the sand you just keep going and spending money no matter what right so masters is good we talked about willies before too right masters was a horrible failure i don't think it was that i don't know i'm on i'm out in the wilderness on this by myself i don't think it was a dumb idea to try 100 i mean it was a very very good idea in fact i actually believe they pulled the pin on that too quickly because they lost investor support yeah we should have kept going they never got a chance to get to scale we're talking about scale right they they opened a few they had some teething problems the mistake was probably they opened too many but not enough you either you should open one and get it really really really right and then try and roll it out or you open a lot and just suck it for up five years and just really spend the time but the investment community was so brutal honestly i i think it's true to say that basically they the management lost their nerve looked at the investor response and went they all hate it the share price is down we've got to fix this.

40:30We've got to fix it. I've got to shut other things and get on with it. Yep, yep. And look, it wasn't the greatest rollout in the rest of it, but was it a mistake to try? I don't think so. I mean, again, in hindsight, well, it didn't work out, but it wasn't obvious that it wouldn't work out. I mean, on paper, they've got all the advantages that Wesfarm has had, you know, and it didn't work out. But, you know, and I agree with you. I think they probably did give up too soon. But, you know, there is also something to be saying, I'm like, okay, try to pull back and that's fine, right? And then there is a reality out there, parallel reality where it never worked and they just continue to throw hundreds and hundreds and hundreds of millions at it.

41:09And this wonderful supermarket business underneath it all just completely obscured by this malinvestment. So it's hard, mate. It's really hard. Hey, the other thing we should, so I guess just to finish this point here, you want to, if you'd be fancy, you'd call it more of a segment analysis. but tease apart the business where are the sales coming from the expense because we're talking about expenses the expenses that we have what are just sort of maintenance expenses like it's just keep the lights on keep things ticking over versus what are the expenses that relate to to growing future earnings the classic one you see even in tech or especially in tech are all the sales and marketing expenses because no one knows about your product it's huge upfront expense you know moving into a new market, you've got to spend a lot of money to sort of do that.

42:02And it's not a dumb thing to do, you know, in all cases, it needs to be done prudently, it needs to be done in a way that's sort of sustainable, etc, etc. But it's, it's in understanding the different components and segments of the business, you get a much clearer picture of what things could look like in the future, which is going to be much more valuable than a point in time consideration. I will say quickly before we move off this, in terms of expenses and the decisions management make, I think it's not unreasonable to suggest, no guarantees because no one knows the counterfactual. We don't know what would have happened had circumstances been different.

42:41As much as Xero spent a lot of money trying to break into the US and very tough against a dominant incumbent like Intuit with QuickBooks, I would actually suggest to you that as much as we talked about, you know, throwing good money after bad and wasting money and all that kind of stuff, I think Xero's biggest failing was actually not getting there quickly enough. Yeah. And you see, when we talk about businesses who are spending up big in a land grab, the idea of like, we've got to get there first and get big. Uber got there first in rideshare, right? Had it been slower to grow, would Didi or Ola or one of those others have got there first?

43:19Lyft? Maybe, yeah. think about myspace and facebook different technology yes different times yes had myspace been six seven times ten times bigger than it was would facebook have got enough traction maybe maybe it wouldn't be the first you know kodak got beaten by digital cameras but when you're woolworths someone else try to open another thousand supermarkets and outcompete you is it's inconceivable because the market isn't there so there's also you know you don't want to go too late you don't want to waste money you don't want to do things in vain but it's also exactly why you know zero was the first mover in new zealand it was the first mover in australia if if ensure to beat them here they try to come up with a better mousetrap zero might be objectively better than quickbooks for all i know i mean they're all much on much as far as i'm concerned but let's say let's say it's a little bit better it wouldn't have mattered one if quickbooks had on their with their online cloud accounting software colonized the country first Xero would have had no chance.

44:13So being there first really does matter in some of these, particularly software, particularly technology. So spending up on those expenses, back to the point of the conversation, can actually be really useful. And it is why these companies make these big bets. And for all of those companies that try and fail, and we say, what were you wasting all that money trying to get to the US for? Well, again, I don't think Xero's mistake was the amount of money it spent. It was spending it too late. Once effectively, the race had kind of been run and won. it was always a bit player and probably was never going to be able to seed or to get back that control or that market share at sort in the US because Intuitars got there so much quicker.

44:51There's a really nice metric for these kinds of companies, LTV over CAC, which is the lifetime value of a customer divided by the client acquisition costs. And you want that to be a pretty nice ratio. Now think about it on a subscription basis, like with Xero. So you sign up a customer, I've had to pay marketing, I've had to onboard them, all of that money is out the door on day one. And they're only paying me their first year subscription, maybe they're paying month to month subscription. So the money that comes in is awful. So I've spent all this money and a tiny bit of money comes back. But if you're something like Xero or something has very low churn, very high retention, just one's the inverse of the other.

45:31And the average customer lifetime is eight years. And so I can look at the maths and say, well, wait a sec. If the lifetime value of my average customer is$10 ,000 and it costs me$3 ,000 to get that, I should be spending as much money as I possibly can. And it's not going to show up. In fact, as I grow, my loss is going to accelerate. It's hard to visualize, I understand, but the loss will accelerate because all of these costs are being booked up front, up front, up front. but I'm actually locking in customers that will be with me for year after year. And once they're on board, then there's hardly any cost to go in and service them.

46:10And so that's a really nice metric to look like in that situation. Hey, before we, I know, I know we're very good at saying end another thing, but end another thing. We touched on something before, which I wouldn't mind you to expand on. When we talked about the steel mill example. Now, it's not exactly like that because even though - Don't do this to me. I'm sorry. Go on, go on. But we have to be complete. So when you - It costs you 10 million bills. I don't know. It's obviously a lot more than 10 million. I don't know what a steel mill costs. Let's call it a billion dollars. It costs a billion dollars to bill.

46:47Pick a number. You actually don't show a billion dollar cost on your profit and loss statement, on your income statement. Correct. What you do on your cash flow statement, absolutely you do. because the cash is gone. But on an income statement, you don't. Why not? That seems a bit dodgy. Why am I not accounting for all of that cost? I'm going to tell you about exactly that in a minute because we're going to get to depreciation, but I'm going to make you hold that thought. Okay, okay. So I'm jumping ahead. No, it's a very good point, but rather than do it twice, I'm going to get you to hold that thought.

47:20Okay. I'm just going to mention on LTV and CAC, lifetime value divided by customer acquisition cost. i i think what's really fascinating is we found new ways and really clever ways of describing these things happening because of the software as a service industry because of the way they run their businesses i just wanted to make the point i attended this for time i'm not because i'm a luddite but it's also worth using that that the framework didn't exist really in a really clever way because we couldn't do the maths frankly before this but think about again because in front of me think about coca-cola the the bottling oh sorry the the drinks company right back in 1896 or 1886 or something um some bloke decided to put some black stuff and some drugs we can only put in soft drinks and other things you know into a soft drink uh make them in they were made up in soda fountains on site that's how they originally you think about the mcdonald's you know that's literally the first version of a of a coke before they bottled and canned it um and he spent they spent years and years and millions and millions of dollars, certainly in modern currency, if we adjusted it for inflation and everything else, building this brand called Coca-Cola to the point where you say Coca-Cola as a byword.

48:28We don't really even think about it, but think about the lifetime value of the marketing in the early 1900s that created this powerhouse brand that's been around for 130 odd years. Now, it's not customer acquisition cost in the traditional sense. It's not lifetime value because frankly, All of its early customers are now dead. But the idea of over-investing in something, now, you've got to be right. There's no point in over-investing if you're wrong. But if you spend, Amazon did this for a long time, right? They just spent and spent, built out the acquisition, built out the logistics pipeline.

49:02They built out their pricing model. They basically look, I don't want to make any money now. I'm going to over-invest in building this thing, whatever the thing is. Cope was a brand. Amazon was a scale distribution network. Zero is a, hopefully for them, the best cloud accounting software out there. You spend less money up front. Say, if I do this really well, if zero becomes a byword for cloud accounting in Australia, which guess what it is, how much is that going to be worth to me? And it's not even the LTV and the current customer acquisition cost. It's when you go to the accountant, he says, well, I'll take you on, but you got to use zero.

49:32The cost of acquiring me as a customer was literally exactly zero, not zero with the next, zero with a Z, because I'm like, well, I want to use MYAB. Well, I only take zero clients. Okay, I'll use zero. And zero has gone, beauty. I invested some money 10 years ago that I can't even directly put down to Scott Phillips, the customer. But that brand I've built, that business I've built, the network I've built, the distribution systems, whatever company, whatever business you think about, those, and we'll go back to Buffett for a second. They're the moats, right? They're the things that make your business defensible or make it easier to acquire customers or keep your competitors at bay.

50:08whatever you do to widen that moat again software really simple lifetime value customer acquisition cost the math is easy but anything you can do to say use me instead of them in whatever form it can pay for decades and decades and decades and that's where if you find the right business with some of those characteristics it can be really really useful 100 % yep well said Motley Fool Money for more subscribe to the free newsletter at fool.com.au forward slash listener

50:38Let's talk about BS earnings. I'm not going to use the phrase Charlie Munger would. I wouldn't. Charlie's older than me and richer than me. BS earnings. There's this thing called EBITDA. Now, I reckon 99.483 % of our listeners have heard of the phrase or the term EBITDA. It stands for earnings before interest, taxes, depreciation, and amortization. Charlie would call it BS earnings. Others have called it earnings before everything else. in any of those circumstances. I think this is a controversial number that has its uses, has its detractors. Mike, tell us about EBITDA. It can be useful. It more aligns with cash flows because depreciation and amortization are non-cash charges.

51:27They're costs. I don't think it's fair to exclude them, frankly, in a lot of cases. but I'm trying to sort of see through to what the economic machine kind of looks like and to get a little bit more complicated it allows you to do so in a manner that's a bit more capital structure agnostic and so by that I mean you might have we both might have identical companies in terms of revenue and product and the rest of it you're 100 equity funded where I'm 10 equity funded and the rest is debt. Now I've got an interest cost that you don't have, and that's going to change then pros and cons with all of that.

52:05But if I just want to sort of say, well, just look, forgetting how the thing is structured, you know, relative to what sort of there, what's the kind of operating profit that I'm getting on the back of that. So it can be pretty useful. Tax, I think is worthwhile to ignore because that's not up to the company really, unless they decide that they want to do something really dodgy. But that's why you would use it. Yeah. So let's look at a fair example. Amortization costs. So let's say I acquire your company and you've got a client list there. Now the accounting rules will sort of say, well, amortization and depreciation are exactly the same in principle.

52:50It's just that one refers to sort of hard assets, the other refers to more of intangible assets, like brands and those kinds of, well, actually brands, not a great example, but like customer lists. Now, the accountants have to come up with some kind of way that we sort of amortize that over a period of time. But if I look at that and go, actually, those clients hang around for a very, very long time. I know the accountants have to be prudent and conservative and account for that, but these are absolutely non-cash costs and i you know and and it's it's okay i think to ignore that kind of stuff if i'm a business catapult i'll go catapult again just because it's fresh fresh in mind um they build these little devices that the the um sports people wear on on their backs and they they they pay for that up front um but then they depreciate the cost over time and that's a real cost i mean that it's just you can spread it out or you can wear it up front but it's a real cost and they're things that to my mind are less reasonable to ignore i don't know what would you add there's a lot to say here there's a lot to say i'm gonna i'm gonna start by going back to ebitda for a second before we go back to the cost that we're excluding um i often have used in my writing particularly for members the phrase operating profit to cover ebitda now there are different people have different definitions of all these things which is why they're all a bit messy but effectively essentially EBITDA gives you a sense of before you as you said already mate account for maybe the way the sausage is made but some really important parts of it just if you own this business and you just said look I've bought the stuff I've made the thing I've sold the thing I've paid the bills what's what's left and a little bit like gross profit it's an interesting stopover on the way to the bottom line because it kind of gives you a sense of you know how well is this business doing under its own steam.

54:45Again, not the other things don't matter or don't exist, but just separate to some of those non-cash charges, separate to tax, which does have to be paid, particularly when you make a profit or interest, if you've got debt, those things are real. But just the fundamental operating business units themselves, how's that looking? And I think it is useful. It's not an end in itself. And when companies talk about it, they're trying to get you to ignore the fact that other things are changing, usually, or they're not profitable at the bottom line. Look, we're a bit dark positive, so you're still losing money.

55:12yeah yeah but we're even positive you know it's that kind of stuff so be careful of that also be careful particularly right now interest costs are going up right because interest rates are going up so of course every company is going to want you to ignore the fact the cost of their debt is increasing and how do you do that you say well look at EBITDA instead and you get some some different things below EBIT below EBITDA sorry mate is EBIT yeah and EBIT basically allows for those depreciation amortization elements no one talks about anymore by the way because they've can just look at EBITDA, which is always even better for them if they're trying to spin a story.

55:44But EBIT used to be the number we looked at, which was effectively, again, removing interest and taxes, which matter, but allowing for that depreciation and amortization. And here's why Charlie Munger calls EBITDA BS earnings, is because if you're a business, and look, Berkshire owns some very capital-intensive businesses like Railroads, right? If you own rolling stock, if you own train carriages and whatever things they put coal in, what are they called? I don't you own those things right yeah yeah things that go choo-choo if you if you own those they've got a finite life right and if you say let's ignore depreciation what you're really saying is let's pretend those things aren't deteriorating over time because what depreciation is this is where the p &l is a real challenge as a as a as a financial statements why you always should look at them all in concert is you know there's no there's no cost on the p &l sorry there's no cost on the cash flow statement of that deterioration.

56:41So let's take an example. I'll go to cash flow and come back. Let's say I buy a car, all right? And that car's P &L is year one, loss or cash outflow, 40 grand. Year two, cash outflow, zero. Year three, cash outflow, zero. Year four, cash outflow, zero. Year 10, buy a new car, cash outflow,$40 ,000. Now in years two through nine, this car doesn't cost me a cent. How good is this? there's no cost to owning that car. It's fantastic. And then you tend to go, why have we also got this$40 ,000 cost? And it's what you talked about before, Andrew, getting back to your question about depreciation is because the P &L is an accounting statement, it's designed to show an asset being used up.

57:23And depreciation is that exact term. It's the using up of existing assets for their useful life so that you get a sense of, on average, over time, how much of this asset's value is being eroded and also frankly it gives you a sense of the replacement not cost in one single year because the cash outflows different but it accounts for that eroding value over time so that you're not left with this really lumpy like cash cash is cash to your point Andrew you spend a billion dollars on a steel mill it's real money it goes out the door it's gone but in year two if you didn't have that depreciation this business looks stupidly profitable look at that I made steel and I had there was no cost of the building that it has to be made in how good is that it's free yeah in other words, if you had to set up a business, you couldn't do it if you didn't allow for depreciation administration using that P &L.

58:11Year two, you'd be like, this steel business, wow, how profitable is this? It's crazy profitable. There's no cost of machinery. There's no cost of land. There's no cost of buildings. There's no cost of the vehicles that are going to break down. These things are all free until they're not. And so that's why the accountants, they call it the matching principle. It's supposed to match the, in some cases, revenue recognition. We talked about it at the very top, but also things like the eroding value of fixed assets. And so those things matter. And that's why, long answer to your point, mate, but it's why Charlie Munger looks at it and calls it BS earnings because it pretends there is no cost to deteriorating real assets.

58:45And of course there absolutely is. Those bills have to be paid. And if you ignore them from that calculation, you look more profitable than you are because it looks like there's no carrying cost of that deterioration. Yeah. I mean, there's nothing fishy going on here, right? You just need to be aware of these things. And you will see these big mismatches when you look. By the way, we're talking a lot about the profit and loss. I mean, you've got to look at the three main ones, the balance sheet, cash flow statement, all together. And that's why you need to take that holistic view. But it will help explain a lot of these things.

59:18By the way, here's another nice little thing. I don't mind companies that have just gone through a very extensive CapEx cycle. CapEx is short for capital expenditure. So they've spent a whole bunch of money on plant and equipment. and uh you know people people see that and they go oh my gosh look at all the cash that they're bleeding cash flow negative yeah but it's like if that if that investment is then going to carry them for the next 10 years yeah you're right the profit and loss will show the depreciation cost and all of that but you know cash the old saying is that sales is vanity profit is sanity and cash is king and and it's like well you know it is it is what it is but wow there there are i know and and look it's cash that dividends are paid out of too is well right so if they have now spent all of this money up front and their profit is going to be reported in future years accounting for that annualized depreciation cost as it rightly should be but i know that the cash conversion there is actually going to be pretty good right like i i've i can sort of rest on that investment for a long long long long time so that's just something something else can that can be pretty nice on the converse the inverse of that is the company that's really put off its capex and yeah you know it's sort of like someone's like quantus maybe yeah i wasn't gonna say it i wasn't gonna say it but the fleet's getting very old enough to be replaced at some point gonna have to be replaced And again, it won't be obvious on the income statement, but on the cash flow statement, it will be.

1:00:50And yeah, it's just something to be mindful of. You know, a nice way just to tie all of those three together, those statements, is that really the balance sheet is the central, the one, the way I like to think of it. It's a point in time because just at the end of the financial year, what do we own? What do we owe? What's the difference? That's basically what it tells you. Yeah, absolutely. But they're joined together. So what you have at the cash flow statement links you to the asset side of the balance sheet, cash. How has that changed throughout the year? It's a very big item there, or hopefully a big item on the balance sheet.

1:01:24And the income statement is going to show you how the equity changes. So if you sort of, it's hard to again visualize, we've got the balance sheet in the middle. At the top there, you've got cash flow showing you how cash changes. At the bottom, you've got the income statement showing you how income changes. and cash flow and income statement are not a point in time. They're over a period, so usually a year. It's a really nice way of tying them all together. And again, why I say you really want to take a holistic view with all of these things.

1:01:56Let's – I thought I lost you for a second there. Zoom in. No, I'm just thinking. We've gone through the P &L beautifully, mate, and we'll go through some ratios next time. what i wanted to just finish up with is just thinking through i want to go back to your point or just pick up that point of the way you think about these statements side by side because i used to be i think i've said this before i was someone who used to say pnl's the pnl's the pnl the accountants there's rules they have to do things the way they have to do them the pnl's king price to earnings or share price earnings we'll talk about ratios earnings is earnings that's the number.

1:02:34That's what matters. We'll use earnings. And then I was kind of convinced to your point, well, accountants can fiddle almost anything they want and not even necessarily improperly, though sometimes improperly. If a business wants to make things look different, you can do that reasonably easy with revenue recognition. You can do that with provisions, for example. The provisions for bad and doubtful debts in most years are one of the biggest impacts on bank profitability, for example. Probably everything else they do. The accounting decision of, we've got too much money put aside or not enough money put aside whenever they change that number that's a massive swing factor on their on their reported profits yeah um and right through the pnl so it's okay all right all right you know as you as you said you know um cash is king okay let's use the cash flow statement but then you go back to and i've said this already about you know um some of those big lumpy costs in some years cash flows flowing out the door looks terrible other years nothing goes out the door everything comes in because all of a sudden your your your customers all pay you in one lump they pay you on the 1st of july rather than the 30th of june and things look very different all they do the reverse um or you've got big you know capital equipment like your billion dollar steel mill which is now the official price of a steel mill but they don't ever ask me the answer is going to be a billion dollars um you've got a billion steel mill or you've got a hundred thousand dollars spent on a software upgrade once every five years or whatever it is yeah and so these are really lumpy now they should be because that's absolutely the way you and i run our own bank accounts some years are good some years some years I've got to buy that car, I'm going to pay cash and my cash flow statement looks terrible.

1:04:02Other years I don't have to buy a new car, it looks great. I don't run a P &L, I don't have an accrual system for my personal expenses. We run on cash flow and that makes a whole lot of sense. But I have to say, mate, I've kind of come back to, as you say, those three statements together really, really, really matter. What are the assets of the business on the balance sheet? We won't go through all these statements, I'm going to go through them one by one, we'll just through the P &L and kind of talk about how they matter. But that's why I wanted to bring it up just at the end here is, you know, what assets do I have?

1:04:31What debt do I have? Think about, you know, the I in the EBITDA or EBIT earnings before interest and taxes. Now, year on year, the interest is interesting. But if I'm looking forward as an investor, I'm going to say to myself, hang on, if rates have just gone up a lot, spoiler alert, they have, then the last year's interest bill is not particularly useful to me. What I care about is what sort of debt has this company got and how is interest bill likely to change okay well that's the balance sheet you're going to find that information yeah um you're not going to say year on year you know sales are up 10 therefore interest is up 10 doesn't work that way we all know that yeah so you want to look at that uh i there's an ongoing argument about when you develop new it systems some companies expense them all some companies expense them all so well it's new i tell you with development we're going to expense it in the current year because the money's been spent and it's gone and that's seen as more conservative because they're not pretending that they can well they say capitalize it and then depreciation, we talked about depreciation, they could amortize that cost over multiple years.

1:05:26They say, well, I built a new computer. It's going to last five years. So I'll do a fifth of it every year. They're allowed to do that. They're also allowed to say, we spent the money. Let's just write it off. One off cash flow. It's an expense. Gone. The money's out the door. It's done. A lot of investors say, that's the best way. Expense it straight up. That way, you're not carrying any pretend costs. You've recognized all that cost. It's all done. I used to be in that camp. I've completely changed around, I have to say to you. because of that lumpiness I talked about with the new car or the steel mill, the fact that there's going to be an ongoing cost of this, because if you expense it in year one, and you don't recognize any expense in year two, three, or four, the analyst who looks at the last three years' earnings in year four says, well, that's a really profitable business.

1:06:07That's fantastic. Obviously, this is what steady state looks like. Year five turns up, bang, million dollars of software development costs. Where the hell did that come from? So I have absolutely changed my tune. Now, companies do use it to play silly buggers, and that's hopefully the biggest lesson of all this is, as you like to say, it depends, but also check very carefully and read and understand the relationships. But I'm now someone who says, actually, I want to see it in the P &L. I want a P &L as my primary statement, cross-checked with, validated by the cash flow statement, so I understand where the differences are, I understand why those differences are made.

1:06:43But to my mind, accrual accounting is one of the great wonders of modern business. We don't have banking without it. We don't have business without it. We don't have double-entry bookkeeping as the basis of modern business. That idea of, and I won't explain double-entry bookkeeping, but that idea of using the accounting rules to determine a profit and loss, not just a cash-in flow, outflow, to my mind is actually more important than I used to. Again, I used to love it. The only thing I'd look at, then I went only cash flow, mostly cash flow for a while. I'm now back on P &L wins with verification from the cash flow.

1:07:15What about you? Yeah, I think that's really fair. I mean, I just think they're all important. They all just tell you different things and it's just worth having that sanity check. I'll give you a good example. It's come to mind. There's a company I really love and I've lamented that I don't know why I don't own this because I've always gone, oh, it's a bit expensive. But it's a company called Objective Corp. They do sort of enterprise software for government and that kind of stuff. I mean, just insanely net profit margins are 20%. What's interesting though, that 20 % net margin is with, I think it's zero capitalized development costs, right?

1:07:53So if they wanted to, they could say, well, actually we spend all, I mean, the biggest part of their expense is all these highly paid developers who write all the code and maintain the software. That's their expense largely. They could say, well, we're building software that should last for like five years, so we're only going to book a fifth of the cost. Now imagine what the profit looks like. Now they've not done that. And this is actually a bit of a pet peeve when it comes to software companies because too many capitalize too much of their expenses. And I can tell you, having built software, that it never ends, right?

1:08:26It never, ever bloody ends. There's always something to upgrade and fix and, you know, new features and the rest of it. So they just say we're getting ultra-conservative response. Every single cent that we pay to our developers, we expense in full each year. Now, if you didn't know, I mean, actually looking at it, you'd think, well, it's still amazingly profitable. But when you look at it like on a comparative basis with other people that do similar kinds of things, you realize just how spectacularly profitable this business is. And so there is, again, there's nothing illegal about any of this.

1:09:02There is an argument to be made for both sides. It is a question of discretion, but you want to understand which way they're going about it. And for my money, a company like that delivers those net margins without capitalizing their development costs is something really special.

1:09:27I'm going to go down a whole other rabbit hole. I'm going to pull myself off here because it's too dangerous. I can see the wheels turning. No, no, no. So look, I think hopefully we've given our listeners a really good run through the profit loss statement and kind of then referenced it where we needed to with cash flow and balance sheet. It is not, look, I have done accounting at uni. I've done accounting as a, I've done a graduate diploma of accounting, believe it or not for my sins. Andrew and I have studied businesses for years. This podcast will not be enough for anybody to understand what's going on, but it should be enough.

1:10:01It should be enough to give you a really, really good head start. I would encourage anyone who's even slightly interested this weekend, go to your favorite company's website, make it something simple, make it Woolies or make it, I don't know, something really, really super simple just to start with, right? Not a bank, not an insurance company. Right, not a bank. Don't even go to a software company for mine for now, mate, because all that DNA stuff that goes on. Try and get a very simple, understandable operating business. No conglomerates, nothing with too many business. Like try and get a really, really super understandable single business.

1:10:34Do you have any particular better ideas? I'll give you a bit of homework. Yeah. No one has heard of this. A company called Supply Networks. It's really small. When I say really small, it's half a billion dollar company. It's all relative, right? This is why I sort of lament at people going, oh, small caps, they're tiny. It's like, no, not really. This is a$500 million company. It's got wonderful. I think it's done really well over time. They provide aftermarket parts to commercial vehicles, buses, trucks. If you know BAPCOR, It's a bit like that, except for trucks. And that's a nice clean – that's a pretty clean set of financials.

1:11:08And it's a – yeah, it covers – I think looking through that, you'll get a good sense of everything that we touched on, particularly with some of the investments they've made recently in some supply centers, distribution centers and the like. But yeah, one to look at. There you go. Supply Networks or Woolies, grab your favorite company, make it simple, and go and have a look. just download it from the investor's website just go to the individual company's website or type in Woolworths Investor Centre or Supply Networks Investor Centre or something you'll find it download the most recent annual report not the announcement not the presentation grab the annual report and flick through you might have to just you know control F or command F it'll be two thirds of the way through it income statement or something yeah it's in the cheap paper because you know the glossy stuff's up the front although these days people do it on screens anyway but go to that page and just have a look down the line as you go really get a sense of what's driving each of those lines look at look at the and by the way do some calculations look at the gross profit understand how it's changed year on year look at the expenses see which expenses going up and going down what way our salaries going up or are they going down is is the interest cost going up and going down look at the way the bottom line we didn't ever talk about NPAT by the way which is actually just what's left net profit after tax when everything's said and done the money that's left over is the money that's available to shareholders we probably should have mentioned that at least called it out specifically but look at what's changed on that line and see how those numbers have changed and by the way if you're also interested i think this is a bit of a uh it was a bit of a beat up it was a few weeks ago now because we're pre-recording this but in middle of may it's 22nd to may i think it was there's an article in the guardian about woolies and coals gross margins increasing now the company the paper says it was profiteering i don't necessarily think it was i don't own those companies so i don't care Anyway, this is the language that people started to talk about.

1:12:57And the argument there is, will these put their price up and Coles put their price up faster than their costs went up. So have a look at that and then go back to the P &L and look at what other costs went up. Did their supply costs go up? Did the distribution costs go up? Did the staffing costs go up? That'll give you a really nice sense of just how some of these things move over time. Then by all means, go to the zeros of the world and look at that and see how much money they're spending on marketing compared to their sales, for example. Or have a look at Neomap. Again, it's not listed. There might be some old ones out there.

1:13:22But you can actually start to, it's a bit nerdy and maybe people will stop at two or three companies and that's fine. Maybe you don't want to do any of them at all, which is also completely fine. But I think you'll really get a sense of it. And then also, last bit of homework, go to those companies, go back then to the presentations they release and look at what numbers they highlight. Is it EBITDA? Is it EBIT? Is it NPAT? Is it something else? Is it gross margin? What else do they talk about? There's a famous company that went broke about a dozen years ago, Ram, not actually that famous, but it went broke about a dozen years ago.

1:13:53and their sales were down, their profit was – they made a loss. This was an awful, awful, awful set of statements. And their headline was gross margin percentage increases. It was literally the only thing they could find in their entire P &L. No one ever, ever, ever talks about your gross margin. As if it's ever going to work. Unless – As if it's ever going to work anyways. Like, oh, I guess I'll stop reading at this point. Yeah. Yeah, exactly. Anyway, but yeah, you do get a sense of the things that move around and why they move. Can I do, before you do, sorry, I think we've talked, and this is a whole other area which we won't go into, but we have often talked about valuation and its importance and the rest of it.

1:14:33We're going to do that next time. And so I'm really keen to dig into that. But this is, I think we are both on the same page when we say that you can sort of get a little bit overly confident in the false precision that these approaches can do. Yes. But I think they're very valuable because if you were to try and attempt a discounted cash flow valuation, you break open a spreadsheet, what you'll do, I think what I do and I think what most people do is you sort of start with the top line. Again, sales, nice and easy. How's that going to grow? And then on each of those line items, or the big ones at least, you'll look at, well, how does that change, right?

1:15:12Now, they're all guesses. They're all guesses. But that's going to really give you a good sense. This is why spreadsheets are so wonderful, I think, you know, because, you know, it's much easier than doing a pen and paper and a calculator. But you will be able to sort of just move certain dials up or down and you will see how radically some of these, like the bottom line actually changes as a result of that. But one of the things that I really like about it is the rules of thumb that you can apply on it. Because sometimes you do these things and you come in and go, wow, in five years time, it's going to be on a 48 % net margin and rah, rah, rah.

1:15:45It's probably something you've made a bad assumption somewhere, if that's the case. That's right. You count on one hand the number of companies that sort of enjoy 50 % net margins, especially in the public domain. So it's a – but it is a nice exercise because of all the concepts that we're talking about. It will force you to go through and think about these things. When we're talking to CEOs with Strawman in the meetings that we do, we're often sort of saying, you know, well, how's your cost base looking? how do you expect that to change over the years? How have margins impacted on the gross basis and how is that likely to change?

1:16:25An analyst asks these questions a lot because they are so important to how everything sort of washes out in the end. Again, don't get lost in hyper-specificity and start believing forecasts for facts, but the exercise will be valuable just from an educational standpoint. yeah i like that mate that's a really lovely way to finish off hey um should we do ratios and valuation next time yeah i'm keen yeah lots lots to talk about there you go if you love this podcast thank you for sticking with us we know it's very accounting heavy we've tried to make it interesting we tried to make it useful we try to make it practical because those are the things that matter for investors but they also are you know if you've had to wade through this i'm gonna actually speak of homework have another listen to it if you need to if you're someone who's just you don't have a finance backer, you have a business backer and you're like, I kind of get what they mean.

1:17:13I think it kind of makes sense, but I'm not sure. Do yourself a favor, not because I want you to hear me bang on twice, but just really try and knuckle down on this one because if you get this stuff right, if you can really give yourself a solid foundation, it's a really, really great way to start thinking about businesses themselves. Not even stocks, just businesses themselves. If you can understand some of this stuff, it'll put you in very, very good steadies. I'll even go further than that. I mean, the wonderful thing these days is that there's so much great stuff for free online even just youtube right you know that there are all kinds of people are going to wonderful detail khan academy has some good stuff you know it's all good and i would say look i'm i'm just a bit slow so i'm happy to say this but it took me years to i'm not even at the point now where i'm super confident with it right like i think the more you know what's it called the dunning kruger effect the less you know the more confident you are and i think the more you know the more you start to realize the limitations of of your capacity but i i i can speak personally it took me a long time to really have the penny drop on i mean i think i could quickly regurgitate the right words but but to to really know them and understand well understand them better is a better way of saying it took a long time and I think it's an ongoing process it was interesting when you were just saying before it's like I used to think this and now I think that in terms of the income statement I think that's actually I think that's great that that that that you've got that flexibility of thinking and it could change again right like it will you will go totally yeah journey right and some things will take a while to stick others will get very quickly and then you just come back to things and just look at them through wiser more experienced eyes down the track it's always going to be intimidating but here's the other thing i would say it's a very very deep rabbit hole but with investing you don't have to be the smartest investor to do well you just kind of have to be in the top 51 right you know what i mean like if you if you if you know a little bit you probably know a lot more than a lot of the other quote unquote retail investors that are out there right you're it's a it's a if you're looking for an edge and frankly if you're stock picking you need to try and have an edge that's a great way that is a great way to have an edge for people who are only looking at you know oh it's you know everyone's going to eat chocolate so i'm going to buy a chocolate company all these first level thinking kind of things or you know all the share price is up so therefore it must be good a little bit of a little bit of knowledge can be dangerous but but i also think um it is something that's going to put you you You don't have to be a grand master before you're reaping the benefits of learning some of these concepts.

1:20:00Hey, not only that, by the way, you talk about being better than other retail investors. You can actually be reasonably better than a lot of fund managers because – and here's the thing, right? To your point, I went to uni. I've done a graduate deployment. I've done a Bachelor of Commerce, and I learned a lot about accounting. i did one course uh called account uh finance for non-financial manager i think it was called and speaking of opening your eyes that was it was just presented well and i hope we've done a half-descent job today of explaining some of this stuff because literally that course went from here's the accounting theory actually he said this applies to business i was like oh oh oh now i get it and it was a really it's again scars from the eyes experience where i literally went from understanding everything.

1:20:45There's the old saying about knowing the price of everything, the value of nothing. And knowing just the basic accounting is the price of everything. That's really valuable because you can't know the value without knowing the price. But to then work out the value of something is to apply that price to what you have and say, so what is that telling me? And again, let's not go on for going on, but your point about learning and learning and learning over time, it truly is getting these things roughly and then doing it over and over again until patterns start to emerge, kind of Da Vinci code stuff, right?

1:21:14So all of a sudden, oh, now I get it. Oh, now I recognize that thing. I remember that thing happened over there. I remember Andrew and Scott said that thing about that. These things start, they genuinely build on themselves. And I really want people to - Compound. I had a member. You had a member who messaged on one of our message boards for our new services who said, I love the podcast, even if I don't understand everything you're saying. Thank you, Amanda, if you're listening. And I was grateful to the podcast. I feel a bit guilty that we didn't make ourselves understandable enough. But over time, these things, I promise you, even if it's weird and doesn't make any sense right now, these sort of, hopefully this podcast and others will build and build and build and build and build.

1:21:52And you get to that point where you think, okay, now it starts to make sense. And it's like every skill you learn, right? You play the guitar, you pluck the string, you try and play an E, you hold your finger down the fretboard properly. Oh, that's a bit ugly. Oh, that's okay. That's a bit better. Now the B. Oh no, that sounds terrible. Now E to B quickly. Oh, I can't do that. all of a sudden you're playing you know not necessarily spectacularly but well enough classical gas it is literally like classical gas it's like learning any any new uh any new skill you don't need tommy emmanuel but as as ram says you you could be you know a possibly good guitarist to pay to play in a pub band on a on a wednesday night at the local rsl and and that's that's going to get you a really good investment return and you're going to have fun and you're going to enjoy it and it's going to make sense and that's that's worth striving for and uh and another thing here we go we're into the second hour here but well into the second hour but just bring it back to bring it back to commonsensical kind of things i mean think about it what do i want for a business well i want sales to grow and i want and i want that to be profitable growth and i want to be able to grow without having to throw a huge amount of money at the damn thing and when all is said and done i want lots of money left over after i've accounted for depreciation after i've accounted for tax after i've accounted for interest i mean that's it full stop that's what i want All of the rest is just filling in the detail to get confidence around that.

1:23:11And that's why Buffett's investing is simple but not easy. I mean, it's very simple. Yes, more sales, please, and more money left over after I've made them. That's what I want, period. And more money after that next year than the year before, at a reasonable price, and all of a sudden you're there. This is just filling – it's just fleshing it out to make sure that that is on track. And, yeah, practice makes perfect, and you'll get there. And another thing. No, don't. Cheers.