As I've discovered with other chapters, Graham & Dodd's relaxed style of writing makes reading the book deceptively easy. Its when you try to apply the concepts for yourself that you discover how much information the book imparts. To overcome this, I've decided to "divide and conquer", as they say in the IT world and tackle this chapter over several posts (hopefully in intervals shorter than six months, or I will have died of old age before finishing the book).
The "Income Account", or "Income Statement" or "Profit and Loss" or (as I prefer) "the P&L" is perhaps the most important of the three financial statements provided in a company's annual report. This is because it is generally accepted that a share's worth is the discounted value of future dividends and the P&L contains the most relevant information to determine this. (Refer to the last couple of paragraphs of my post "What is a share?" for an explanation of discounting.)
One of the questions to be asked when examining a P&L is "What are the true earnings for the period studied?". In a simple world, one would be able to look at the bottom line of a P&L and if it showed a profit of $23.8m, we could say that the true earnings for the period studied were $23.8m. Unfortunately, we live in a very complex world with very complex accounting standards developed to deal with very complex things that people do with money, hence, we need to do a bit more work that this.
There are three elements of a P&L that "require critical interpretation and adjustment":
- Nonrecurrent items (ie things that are one-off's and won't happen again)
- Operations of subsidiaries or affiliates - particularly tricky as you may not be given any details about them other than their profit or loss
- Reserves
Graham and Dodd list nine types of non-recurrent items and point out that they need to be taken out to determine the "ordinary operating results". By doing this, we can get a better idea of the "indicated earning power", which is what you would expect the company to earn each year if business conditions remained the same.
To apply this concept I am going to examine NIB Health Fund's financial result for the year ending 30 June 2009 [specifically the pdf file titled Appendix_4E_Preliminary_Final_Report_30_June_2009.pdf, which I downloaded from NIB's website]. For the time being I'm going to only look at the Consolidated results and ignore the Parent Entity results. I have chosen NIB because I have had a health insurance policy with them for several years and, as a result, when they listed on the ASX they gave me some shares.
NIB's Income Statement is on page 41 of the annual report. NIB's profit for the previous year FY2008 was only $404,000, but increased to $23.8m for FY2009. Coincidentally, a large part of the difference is due to non-recurrent items and so proves a useful example when considering this chapter.
In looking for non-recurrent items the first thing I do is run down the list of figures and compare last year and this year. Any items which differ significantly are likely due to non-recurrent items.
The most obvious thing that first stands out are the two items:
- Other underwriting expenses - demutualisation and listing costs: which was $10.8m in 2008 and $0 in 2009; and
- Other expenses - demutualisation and listing costs: which was $7.6m in 2008 and $0 in 2009.
The third expense that occurs in FY2008 and disappears in FY2009 is a $25m payment to the NIB Foundation. There is no discussion of the Foundation in the FY2009 financial statements, however, the media releases on the NIB Foundation website state that this donation established the Foundation using funds raised for the purpose as part of the ASX listing. The NIB Foundation aims to distribute $2m in grants each year, so presumably they are using the $25m as capital to raise the $2m each year. There is no mention made regarding whether NIB will provide ongoing monetary support to the Foundation, so I’m going to assume that we can exclude it for the purposes of determining NIB's "indicated earning power". As a result, the FY2008 profit lifts to $43.9m and suddenly what on the surface seemed an extraordinary improvement in performance from FY2008 to FY2009 is looking like a dramatic decline.
The next items to look at are Investment Income and Investment Expenses. If we add these two items together they represented on 1% of costs in FY2008 and 0.2% of costs in FY2009, so the temptation is to just ignore them all together. But as this is a learning exercise, we are going to delve in and see what we can find out about them. This will involve reading the dreaded Note 1. Every set of financial statements has a Note 1 - Summary of Significant Accounting Policies. Note 1's set out how the financial statements are put together. Note 1's always consist of several pages of single spaced type in a small font that contains a lot of accounting jargon. This is why I have never before read a Note 1, but I suppose there is a first time for everything.
So, on the third page of NIB's 14-page Note 1, we learn:
- changes in the value of financial assets are put on the profit and loss statement.
- dividends from subsidiaries are put on the profit and loss when the right to receive the dividend has been established - so even though they might not yet have recieved the cash, NIB will report the income as earned on the P&L.
- rent from building they own and lease out is put on the P&L for the period when it should have been received.
All these items are annoyances when it comes to determining a company's "indicated earning power".
Firstly, an increase in value of some shares you own (financial assets), doesn't put money in your pocket - at least, until the time you sell them, when the value would have changed again. So on the one hand, this should be excluded from assessment of indicated earning power (I'm going to go ahead and start calling this "IEP") on the other hand, over the long term, this will come into play.
Secondly, we do not have the financial statements of the subsidiaries so we have no way of assessing their IEP's and therefore no way of assessing likely future dividends and their contribution to NIB's IEP.
Thirdly, we have no details on the rental properties so cannot assess whether the rent is representative of a typical year or whether, for example, a significant tenant is about to vacate and leave 60% of the buildings empty for an indefinite period.
Fourthly, there is no breakdown of the investment income and given it has gone from a positive $8.8m in one year to a negative $1.2m the next, it could do anything in the third year. It may well be that when we examine the balance sheet we will get a better handle on this, but in the mean time, I'm going to fall back on my earlier comment and say that this is such a small part of NIB's IEP and exclude it.
With all these non-recurrent items excluded FY2008 profit becomes $36.4m and FY2009 profit becomes $25.6m and what looked like a good year has turned into a bad year with a 30% drop in profit from FY2008 to FY2009.
For the next post I will read through NIB's annual report and see what they have to say about their results. I will also run this exercise on the FY2010 results and see how the next year has been.
