Financials Demystified: Everything Outside EBIT

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2:06All right, folks. Welcome to Investing for Beginners podcast. Today, Andrew and I are going to continue our exploration of the income statement, and we're going to do a financials demystified, and we're going to talk about everything outside of EBIT or operating income. So everything below that is going to be on the table today. This is Andrew's favorite discussion, favorite topic, so we're going to have some fun today. So Andrew, why don't you kick us off today? Yeah, if you guys don't end up stabbing your eyeballs and having your ears bleed, then this episode has been a success. So first, let's talk about why these things matter.

2:43It's probably an overlooked component. And I would admit I probably overlooked this a little bit too much too. But it does make an impact more in the short term than the long term. I kind of look at it like a blocking and tackling. When companies have to do accounting and they have to do lawyer stuff, it's blocking and tackling. So when it runs smoothly, you don't even realize it's happening. but when it doesn't run smoothly, sometimes that could be symptomatic of bigger issues. So you want to be able to check it. And I think to me, it's fascinating to know. So you're going to just have to grind through this.

3:21Let's talk about taxes first. Well, actually, I kind of want to back up for a second because a company lifecycle will determine oftentimes which parts of these are are relevant to a company. So maybe Dave, you can give us like a super bird's eye view of company's general life cycle, and then I'll touch on which parts of this income statement tends to affect certain companies more than others. Yeah. Yeah. Okay. Good. Very good point. So when you're looking at a company and you're trying to determine their financials and how to interpret them, one thing to keep in mind is where the company is in its life cycle.

4:02So as a general rule, a company will go through a life cycle just like we will as humans. And so when they start off, they're young, they're generating revenue maybe, and they are not generating a lot of profits. And so they will be very young in their life cycle. So think maybe IPO companies or pre-IPO businesses. then once a company comes public, for example, then they will still be generating a lot of revenue and very typically not a lot of profits, but they're still very young in their stage. And as the company kind of moves through its life cycle, it will continue to generate revenues, profitability will start to increase.

4:44At some point, that will start to flatten out and the company will start to become more mature. And as our friend Brian Feraldi would say, It's optimized for profits and it's able to fully fund itself. And companies can stay in and out of these cycles for many years. They can oscillate back and forth between these cycles many times in their lifetime. And then at some point, a company starts to become overmature and will start to decline. Revenues start to fall. Profitability stays really high, but the company just has nowhere to go and has nowhere to grow and it becomes obsolete and eventually will die.

5:21So that is kind of the life cycle, not to be Debbie Downer, but yeah, every company will eventually meet its end. Yeah, totally. So if we're to look at the beginning parts of that, Warren Buffett, one of these obscure nuggets, I remember reading a write-up he did where he had discovered hidden value in tax-deferred liabilities, or I'm sorry, tax-deferred assets. So if Warren Buffett did it, maybe one of us could do it one day too. But basically, to Dave's point, when you are a young company, a lot of these companies are reinvesting for growth and trying to go growth, growth, growth for good reason so they can hit scale and become a leader in their industry and become the undisputed leader ideally.

6:11So as they do that, they get losses. Rather than a company who's optimized for profit has profits, they pay taxes on it. A company that is losing money has the opposite situation. So if you've ever had the pleasant fortune of having bad stock picks and getting a tax write-off at the end of the year because of that, it's very similar for businesses. and what businesses can do and often do is they defer those write-offs and it becomes an asset on their balance sheet and so that's essentially future free cash flow that they're able to offset future taxes using these deferred assets and so yeah it can be a hidden source of value that is not immediately apparent when you're looking at the income statement maybe you're looking at the balance sheet but it becomes apparent in later years because it gets reflected in the income statement.

7:06And that's sometimes where you can see earnings and or free cash flow that is higher than if you are only looking at EBIT, only looking at the operations of the business. And if a company is good at managing their money, maybe they can add an extra level of growth, make a savvy acquisition, do these things that create growth above and beyond what the operating business would have been able to do. So as an example, if we have our ice cream shop that just went public and we are not making money on the stores so we can reinvest and we're building more stores and we're securing outside financing and all of those things, if we were first three years, we lost a hundred million dollars, then year four, if we made a hundred million or were to pay$100 million in tax, I think would be an easier way to say it.

8:02You can offset the$100 million loss from before, use that to offset the future. And so where year four without that deferred tax asset, you would have had to pay whatever the corporate tax rate is at the time and where you operate. That money that would have been deducted from net income is no longer deducted. And so that net income is now higher and it's closer to your EBIT. And yeah, that can be like a cool little nugget, little short-term value finder when you're looking at different businesses. Yeah, that's awesome. Yeah, that's awesome. I remember Buffett talking about that. Wasn't it in one of his earlier partnership letters, I believe, that he made that discovery?

8:46Yeah, he was probably still doing the whole deep value game. Yeah, so that was pretty impressive. So when you're thinking about taxes and how it impacts the analysis of a business, do you look at the life cycle of the business and try to determine maybe how relative that is for the company? And I guess the second question is every company has to pay taxes, right? Yeah. Well, let's be clear. What is the three Ds, right? For people. and it, I guess, applies to businesses as well. Yeah. I can't remember what they are. No, I don't either, but I know what you're talking about. Okay, yeah. Anyway, I don't analyze businesses anymore, but when I used to, if deferred taxes or deferred liabilities seemed really large, then that could be something to dig into.

9:43You can go as deep as Mobison. He calculates ROIC based on what's the cash tax shield, which is a whole another level but if you're looking at investing in businesses for the long term you probably don't have to go that deep into it unless again like I was mentioning if something, a number looks really big that is bigger than normal then you do want to do the extra digging something I will say about that that's interesting and it was a hot topic for a couple years and it's kind of faded in relevancy, but companies will have different tax rates depending on where they do business. So a more international company like a Visa or a MasterCard or Microsoft, where there's a lot of revenues outside of the United States, you'll see a lower tax rate, tax percentage, I call it an effective tax rate.

10:43You'll see that will be lower than a company like martin marietta which is all u.s based and they're paying the u.s corporate tax rate which was i don't know 25 or something so you do see a bigger difference and again if you're only focused on ebit that can be a problem because you're not really going to get the the full breakdown of how ebit actually turns into earnings which is another way of saying also free cash flow So over the long term, earnings and free cash flow tend to be equal. But the taxes and the interest do play a role in that. Yeah, for sure. I know that I was reading about Visa and MasterCard recently.

11:27The companies have not done as well in the market. There's been some pessimism around the businesses. And one of the reasons is their tax rate has been a little more elevated recently. And that stems directly from, I think it might have been Europe, that passed a law mandating a minimum of 15 % tax rate for global companies. Meaning that when MasterCard generates revenue from Thailand, for example, they're going to pay a minimum of 15 % tax rate on that income. And so that has raised Visa and MasterCard's tax rates 2 % or 3 % over the last three or four quarters, which has caused them to be slightly less profitable than they have been in the past.

12:16So it does make an impact and it is something you do need to keep aware of and be cognizant of as you're analyzing any company. So it was something I admit I was not aware of. And then it was brought to my attention and then I read about it and my, huh, okay. So it was, you know, good information to know. Yeah. Is it, I'll just be kind of how I see it is when it comes to taxes. I'm going to assume that with the errors of assumption that are there, assume that whatever the company's current tax rate will probably continue. I remember a lot of people talking about, oh, you know, new administration, what's that going to do the corporate tax rates?

12:58And they're talking about Biden. And I remember that being a big thing back in the day. But if you're buying stocks, any changes to the tax code are going to hit every stock. So yes, the valuation for every stock will probably change if corporate tax rates change. But what is the point in adjusting your DCF by whatever percent for every company you look at if you're still going to pick stocks so they might be more equal than others? I don't know. I mean, if we're talking about global tax maybe versus a domestic tax, then I could see some validity there. But it becomes hard when you invest, especially when you're digging into the nitty gritty of the financials.

13:45You kind of always have to make that decision. How much of this am I really going to have effect which stocks I buy? And how much of this am I going to let go and kind of just say, you know what? most of the companies I buy are going to figure this out. Most of them are going to do the blocking and tackling. It's not always an easy thing to decide to what scale are you going to make that assessment about a stock. Yeah. Yeah. I would totally agree with that. I think I remember watching a valuation seminar from Professor DeModeran and when he was talking about taxes and kind of how to deal with it as far as valuing a company he was basically of the opinion i i i'm going to paraphrase pick a number don't be a hero there's more important parts of the dcf than the tax rate love it yeah yeah no that's perfect yeah yeah i love that i just i very very very i barely uh strongly remember don't be a hero yeah there's other parts that are more important.

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17:15One in particular, interest income, or I'm sorry, interest expense. Yeah, and tied with interest income too, right? Right. Interest expense being important because interest expense, when it becomes too high, that can really pressure a company. and then you will see companies behave in ways that a desperate company would behave in. And so even though interest expense may be high, maybe Wall Street doesn't recognize it's a problem until they go do something silly like sell a unit that was growing really fast just because they have a lot of interest. And then you're shaking your head wondering why they did that and the stock is down and maybe it was because they were pressed by interest expense.

18:01Interest expense being the interest that companies need to pay when they issue debt. I do strongly, based on the way I've perceived the market, which is admittedly a narrow approach because I've always stuck to companies more on the profit optimization, capital return phase. those businesses tend to borrow more, especially the later towards that capital return phase you are. You'll tend to see more companies borrowing, whereas the younger companies who are still trying to make profits, from my understanding, people don't want to finance companies that aren't making profits unless there's some additional upside.

18:47So you'll see a lot of debt, like convertible debt, for example. so that might come with an interest rate but a vast majority of the financing is based on that all option that the lender gets basically okay if your stock goes this high I get shares of your company instead of only just getting the interest for the debt so that's why again we're in the beginning companies maybe you're looking more at that deferred tax asset type deal the more mature companies you're looking at this interest expense because that is something that needs to be managed. And we're all seeing right now how the government is having to deal with interest expense.

19:30And it is almost like compounding where as interest rates rise, an interest expense that was a problem in the past now becomes even more of a problem because you're refinancing at higher rates. So I think ways to look at interest expense that we all do and if we don't we should would be something like a interest coverage ratio do you want to start with that one and kind of explain what that one is and and why it's helpful yeah so the interest coverage ratio is a way of measuring how much how much is the company having to pay in debt payments compared to the earnings that the company generates and so you the the mathematical way you compare it is you look at the interest expense that you would find on the income statement.

20:16You would compare that to the earnings before interest in taxes or EBIT, and that gives you a coverage ratio. And basically what that tells you is how many times over can the company pay for the debt that it is having to pay. This doesn't cover the actual debt repayment. It covers the interest expense on that debt payment. So the vast majority of debt that we deal with, especially Andrew and I dealing with more mature businesses, is the money they get from generating interest in the bond market. So they basically entice investors to invest in the debt of Microsoft, for example, and then the payment that investors get for making that investment, that's the interest expense.

21:01And so that's what they're covering. And so a good way to look at this is the higher the better i think a good cutoff most companies if you see anything under two two and a half two and a half times interest expense run run far away uh and the higher the better so sometimes you'll see companies that have a hundred times interest expense and that's awesome it means that they're in a very strong position so that's that's how i look at it yeah perfect um what about interest income let's talk about the other side because it's like Like what? A company like Google gets interest income? Like tell me more.

21:42Tell me more. So interest income, it can be an amalgamation of different sources of income. So when you look at the income statement, you'll see sometimes some companies will put interest expense and interest income. Sometimes they'll combine them. And so you may see a positive or a negative number. So it can be a little bit confusing, and you'll have to use Control-F to dig a little bit deeper to find out what the exact numbers are all the time. So interest income is the money that they make from investments that they make. So when you look on the balance sheet, you'll see cash and equivalents.

22:21You'll see short-term investments, which are typically in bonds or money markets or things of that nature. So the money that Google makes from those short-term investments is interest income. If the company invests in other businesses, let's say they take a 20 % share in Meta, not that they ever would, but let's say that they did, then any money that they make from that investment goes as part of their investment income. And so all those things kind of play into the investment income of a business. And in some cases, companies that have a very large investment portfolio, I'm looking at you, Berkshire Hathaway, this can have a big contribution to the company's income overall or the loss of the income.

23:10and so that's one thing to always kind of keep in mind when you're looking at the the income statement of the company is where are all the profits coming from and that's this is one of the places that could show up yeah and if you're looking at like a bank or a berkshire or an insurance company where their primary money making is on interest on investments or interest on loans that they're making then you will see that the whole income statements transformed and it looks completely different and it becomes a much bigger impact. So where a traditional, I'm putting that in air quotes, company, you look at gross margin, operating margin, which is EBIT, and then everything else, which is today's episode, gets you to earnings.

23:58For an insurance company or bank, that interest expense, that interest income is a prominent role and that's calculated more so than a gross margin or operating margin would be. Yeah, yeah, for sure. The last thing I think I will throw out there about this particular line item is to keep in mind is if the company has a large equity portfolio, again, Berkshire, Markel, some of the big hyperscalers will have investments in other businesses. Those investments are mark to market. So every quarter they will assess what is the value of Buffett's investment in Apple, for example. And if it's up, then that improves the interest income of Berkshire Hathaway.

24:45If it's down, it could negatively impact the interest income of Berkshire Hathaway. Even though they have not sold any of the investments and realized any of the profits. The powers that be decided for gap accounting rules that equity investments need to be unrealized or realized gains. And so those have to be marked on the income statement. And so it's very important to be aware of that, especially with companies that have larger equity investment portfolios, because that could have a huge swing depending on how the market's going on what you see on the income statement. And sometimes you'll see these headline articles screaming, Berkshire Hathaway, earnings down 30%.

25:29And at first blush, you can go, holy crap, that's terrible. But then when you dig a little deeper, you realize it's all coming from the interest income, which is coming from the stock market has been performing poorly for the quarter and Buffett's investments are down. Then that's negatively, and it has nothing to nothing, I repeat again, nothing to do with the operations of the actual business. And so it's something to be very, very aware of. And the other reason why I mentioned this is when you look at Amazon, you will see this fluctuation from time to time with their company because they have a pretty big stake in Rivian.

26:05And so because of that, the market sometimes loves them and sometimes hates them. And that impacts the financials of Amazon, again, while not relating to the operations of the business in any way, shape, or form. So it's something to always keep in mind when you're thinking about this. So you own Berkshire. So rather than looking at earnings, because you know that earnings will be impacted by the fluctuations of the stocks that they own, what are you looking at instead to decide whether things are smooth sailing or whether, oh, I want to look deeper into what happened two quarters ago or something like that?

26:47For me, I look at operating income for the business, and that's as far as I go. When I look at them, I don't... I mean, I'll look at what's happening with the interest income and whatnot, but I'll look at the operating income of the business because that's really where the money is made is the operations of their insurance businesses as well as all their other either wholly owned or partly owned businesses. And that's where I'll look to see how their company is doing. I've been paying a lot more attention to what's actually happening inside my body when I train lately, especially when I hit a wall with my performance and nothing I do seems to move the needle.

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