We covered over the company name, Smith & Wesson (SWHC), on the statements and asked Hurd how he would review them.
There are two sets of financial statements, the income statement and the balance sheet, and they work in concert. If you want to get to the health of a company, you have to look at both. What we have here is an income statement. It’s going to take you through things like revenue and expenses and tell you about the profitability of the company. That profitability generally turns into cash flow and brings you to the balance sheet.
The more years of financial data you can get, the better, because you get to see a flow. You look at things like revenue, and you look at expenses, and you can start to ask, “What happened year to year?” and start looking at the deltas between the numbers. That’s one methodology for looking at a business.
Another is to simply take the expenses and say, “If you’ve got $1 of revenue and 80¢ of expenses and your profit is 20¢, just tell me what you spend the 80¢ on.” How much on sales? How much on overhead? How much of it do you spend on R&D?
Instead of taking a line-by-line view, take a look at the relationship between expenses to revenue and gross margin to revenue. It will tell you a lot about the choices the company is making about where to invest.
This all comes with a note of caution. Even when you start to analyze these lines for their incremental ups or downs, you may not get clarity. People see a sales expense go up and assume that means there are more salespeople or more selling effort like advertising. Well, frankly, that may not be true, because inside sales expenses there could be other costs that are categorized in sales expenses, but they’re not giving you sales effort in the marketplace. Like office overhead or IT upgrades for the sales team, for example. It’s the same thing with R&D. People think R&D being up or down is some surrogate for the amount of innovation in a company. Not necessarily so: There are things that go on in the R&D line that could be overhead or some other kind of spending that’s not valuable, such as duplicative real estate or human resources costs inherited as part of an acquisition.
There are a lot of people who don’t want to spend time on this type of stuff, but the great thing about numbers is they typically don’t mislead you. They don’t purposely lie to you. If you interrogate them, they’ll reveal things to you, so you have to be able to have enough different looks at them that you can get absolute clarity.
Clearly, what we have here is a manufacturer. They have a large cost of sales, so they’re building a product of some type. They’re not a services company. I would guess they sell their products through some sort of channel. So because they have big [general and administrative] costs, and G&A exceeds their sales and marketing, my inclination would be they must sell at retail or sell through some sort of aggregator process. They have a small relative R&D bill. When you look at this from an R&D perspective, they’re spending less than 1 percent, so this must be a conveyor-belt-oriented branded product. It’s some sort of hard good.
But again, even with those two statements you may never get a complete picture. As I’m here to tell you, many people even inside have a hard time getting all the detail you’d like to get a full view of the health of the company. Then the thing always when you’re running these companies is the quality of the people driving this income statement.
The nice thing about the income statement is that if you understand the strategy, the income statement is the X-ray that shows the health of the patient. —As told to Ashlee Vance