These are the expenses required to keep the business running. Coming back to our hot dog business example, what would the business owner have to do in order to have a thriving business:
- Sales, General and Admin (SG&A): To drive the sales, the hot dog owner may have to spend some money on pamphlets in newspapers and magazines bought in the vicinity of the shop. Seeing the advertisements, people start coming to his shop and the business starts picking up. He may have to continually do this advertising so that his customers or potential customers do not forget about his shop. Not only this, he will have to pay salaries to any employee who would help him out in the business, pay the electricity bills, etc.
- Research and Development: Now our hot dog business owner knows that if he sells the same hot dog, customers will probably not come as often as he wants them to. So he spends some time and money on creating new recipes, new sauces, and tests out various combinations of spices. This process may or may not lead him to create a winner hot dog, but in order to increase the service offering and give new experience to the customers, he has to spend on it.
- Depreciation: Let’s say the owner bought 2 Stalls for $5,000 each when he starts the business. But the Stalls can be used for next 5 years, after which they have enough wear and tear that the owner will have to buy new Stalls. In accounting, instead of using the cash outflow of $10,000 in first year, the businesses account for this outflow throughout the life of the asset, in this case $2,000 every year for 5 years from now ($10,000/5yrs = $2,000 per year).
Applying the above to evaluate any underlying business, we should keep the following in mind:
- SG&A: How much does the company have to spend as a proportion of Revenues on a consistent basis? Are there any huge variations in the past years or are these expenses starting to trend up? If the trend is upwards, a prudent investor would try to find out the reason for this – is it because the industry has become very competitive or it is because the customers have to be persuaded more to buy the products (more marketing)?
- Research & Development: This is a bit tricky expense. Pharmaceutical companies will have R&D as one of the major expenses as they have to consistently strive to invent new drugs. But I would be surprised if the businesses like McDonalds and Coca Cola have R&D expenses significant enough to impact the profits. It depends on the underlying business. If we see that a company has consistently spent x% of Revenues on R&D and has been able to bring out new/improved products which are appreciated by customers, we would not be too tensed seeing this line item.
- Depreciation: This is a very real expense – most of the research analysts tend to add it back to the earnings stating that there is no cash outflow corresponding to this item. But the point to note is that the life of the asset being depreciated is decreasing as well. So the business will have to invest in new assets to replace the old ones or do some maintenance to be able to utilize the asset throughout its life, and this is captured in Depreciation expense.
Chapter 5: Operating Profit/Operating margin
Chapter 3: Revenues, Cost of Goods Sold and Gross Margins