The upcoming reporting season will be unlike any other in the history of the ASX. During the 8-week biannual ‘look-see’ that begins in July, the full extent of the coronavirus-led down-turn will be revealed.
It’s important to not only pay attention to the financial results, but also look beyond the aberration within these distorted numbers to the underlying commentary supporting it. While a handful of shares within certain sectors like healthcare, technology and some retail will present pretty healthy numbers, the bulk of ASX-listed businesses are destined to report a deep sea of red.
The numbers – and outlook – that surface at reporting season can have a significant impact on the long-term value of the shares you own. While you need to know what to look out for at the best of times, in this post-COVID-19 world the stakes for correctly interpreting the tea leaves behind the numbers are higher than ever.
Don’t take headline numbers at face value
It’s important to understand that Australian accounting standards – which differ somewhat from generally accepted accounting principles (GAAP) – afford ASX-listed companies significant wriggle-room with which to weave their magic within their figures.
Be very aware that the headline figures a company releases when in reports are the numbers that paint the best possible picture of the company’s performance. These numbers are also often the ones that most mainstream media will regurgitate.
While some companies treat stakeholders with a high level of transparency, others will try to bury some of the more meaningful numbers that perhaps don’t paint such a rosy picture. That’s not to suggest they’re doing anything illegal, it’s just that there are no real laws or requirements about how a company must structure their announcements, meaning those more important figures can sometimes find themselves pushed further out of sight.
For example, while earnings before interest and tax (EBIT) is often quoted, many businesses will present their ‘underlying EBIT’, which often strip out charges deemed ‘non-operating’. It’s also not uncommon for companies to move line items within their cash flow statement. Again, this is something that is completely within the accounting rules – nothing illegal. Companies can, for example, shift interest expenses from ‘cash flow from operations’ (CFO) to ‘financing cash flow’. The net effect is that this transition could make CFO look decidedly better by comparison.
Another trick that companies use to make a balance sheet look more respectable is off-balance-sheet leverage of minority shareholdings in associate companies. So for example, by only owning 49.9% of a business (and not having ‘control’ of that business), which may carry a lot of debt, companies aren’t obliged to include it on their balance sheet. This means a lot of leverage can be disguised within its consolidated reporting.
Tell-tale signs something’s out of whack
If there’s a sizeable difference between operating earnings (e.g. EBIT) and net profit after tax (NPAT), it may be necessary to find out what it is and why.
In light of the coronavirus-led downturn, which for some companies became a liquidity crisis, this may be a much more acute issue within the upcoming reporting season. With many companies struggling to find the liquidity needed to meet day-to-day requirements, it’s important not to overlook their outstanding short- and long-term debt.
When it comes to debt covenants, try to gain a better understanding of the company’s requirements (e.g. how much cash it must hold, or the earnings it must generate to ensure it does not breach those covenants) and when its debts will come due. The company’s upcoming reports may shed some light on these factors and allow you to gain a better appreciation for how your shares might fare. For example, how will the business cope when any temporary covenant relief offered by the banks is lifted, or if liquidity doesn’t return in the near future. Will it be able to repay its debts, or is there a growing risk that it will not?
Remember, if a company appears to be paying out more than it’s earning, it may be living on borrowed time. If the sky does fall in on these shares, remember a debt-holder and even hybrids have priority over you as a shareholder when it comes to claiming assets.
I find that one of the best ways to get a quick fix on the quality of a company’s balance sheet – and other financial statements – is to check out key performance measures. These include debt levels, cash flow ratio, net-debt to equity, earnings per share, return on equity growth, and the strength of its cash flow relative to reported profits.
Tips to help separate the numbers from the spruiking
Here are 10 ways to ensure you really get to the bottom of a company’s results.
- Have an idea of what you’re expecting from a company before it reports. That way you’ll be in a much better position to determine the strength of the results.
- Read the financial statement before the supporting commentary. If there’s no mention within the commentary of certain key numbers, that may be worth looking into further.
- Compare how a company presented its report in years past. If it has excluded numbers that it previously reported, that may be a yellow flag.
- Examine how well cash has been flowing through the business, and check to see whether profits and cash flow broadly align.
- Check to see if a company has a ‘funding gap’, due to insufficient cash, which is forcing it to take on debt or raise capital.
- Check whether the type of business and its level of expenditure complement the way it chooses to report. Given that profit is an accounting number, you need to understand what’s excluded from underlying earnings. For example, a P/E valuation is more meaningfully applied to companies with an established history of consistent earnings than one that chooses to exclude many ‘one-off’ costs from its profit and loss statement.
- Find out what management is doing for the long term good of the business. In other words, what are its plans for taking the business forward?
- Does the company have a history of poor disclosure and why? Be on the lookout for companies that perennially need to satisfy a ‘please-explain’ to shareholders.
- Look for clues as to how management is responding to its problems.
- Check for guidance on dividend policy and pay-out ratios. Take a close look at the balance sheet and the quality of a company’s cash flow to decipher whether a dividend looks sustainable.
While we believe there are still good buying opportunities in this environment, it is vital to separate the weeds from the flowers. Identify businesses that are capable of flexing their muscles, rather than those simply telling shareholders they have muscles without any evidence to back it up.
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Motley Fool contributor Mark Story has no position in any of the stocks mentioned. The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.
The post What to look for when companies report their post COVID-19 results appeared first on Motley Fool Australia.
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