Having looked at incomes in the last post, I’d like to take this opportunity to dig into the profitability ratios we discussed. Specifically, it’s important to understand how these ratios are impacted by operations, and how it is that an apparent weakness in a given ratio, can actually represent an opportunity to invest during a time of expansion.
Remember, when a company is spending money, they are investing in their ability to create returns for your portfolio. The trick to recognize when it is that these expenses represent an opportunity, and when it is that they represent a weakness in the company’s ability to operate. Below I will talk about a couple of the major expenses from within the ratios above, and how it is that they can represent either a strength or a weakness.
G&A expenses are controversial, in that they reflect a portion of the wages that employees are receiving. It also sometimes represents the fixtures that a company may be using (such as computers and desks). If this expense is extremely high, it is important for an investor to dig into why this is, and whether or not it represents an investment in quality people. O
therwise, you need to ask yourself whether or not these employees need oak tables, designer furnishings, and high-speed computing power available on demand. Otherwise, it represents that a company is investing in the quality of its people, which is an extremely valuable resource in industries where human and knowledge capital play key roles.
Marketing expenses represents a company’s ability to build awareness, and secure revenues. It can arguably be indicative of what portion of a company’s revenues are brand-related, and therefore predictably recurring. Most importantly, it represents the company’s ability to hold a position in the consumers mind in comparison to its competitors. When comparing marketing expenses, take a moment to consider whether or not the company is producing comparable returns against competitors with similar revenues.
Additionally, consider evaluating what it is that the company is actually marketing. In some smaller companies, you might be surprised to learn that a great deal of marketing expenses go into raising more equity, which doesn’t really create much additional value for you as a shareholder. Unfortunately, those companies are too small for you as a personal investor. Focus on companies that can consistently create revenue growth from stable marketing expenses, and focus on buying into the brand.
Inventory controls represent a company’s ability to forecast its operations. If a company is able to consistently handle its inventory, it is more likely that their expectations for the period’s performance will be more accurate.
Contrast this to a situation where you have a company that cannot properly control its production or distribution, and you will find that expenses begin to cascade. Try to focus on consistency in this area, rather than volume. You want a company that knows its capacities, and can apply them towards allocating higher volumes.
