This article appeared in the August 2014 ASX Investor Update email newsletter. To subscribe to this newsletter please register with the MyASX section or visit the About MyASX page for past editions and more details.
Three-step guide to analysing financial statements in upcoming reporting season.
By Richard Hemming, Under the Radar Report
Good old-fashioned number crunching has never been more important, which is what is required for the reporting season in mid-to-late August, when ASX-listed companies, big and small, report their profit results for the 12 months to June 30.
There will be a lot of focus on the outlook statements from all companies but it will be more intense for the bigger companies, simply because they are much more expensive.
Industrial stocks now trade on an average price-earnings (PE) ratio of 16 times, compared to the average 14 for the market, which is being dragged down by mining stocks. Meanwhile, small caps are trading at an average of 12 times, which reflects that risk appetite among investors remains low.
Trading conditions remain difficult for most businesses, but at least this is reflected in the price of small caps. One fund manager we have interviewed is Perpetual's Nathan Parkin, who manages its flagship $7-billion Industrials Fund. He is increasing his weighting in the sector and, conversely, has been taking profits in banks.
Like Parkin, when we look at companies our first two questions are what does the balance sheet look like and where is the cash flow going to come from?
These "show me the money" questions will also be at the front of our mind when ASX-listed companies present their full-year results.
If a company can deliver positive answers to these two questions, you are limiting your potential for loss, which we regard as just as important as the potential for gain.
For small caps, which we classify as companies with market capitalisations of less than $300 million, these results are more important than for their bigger brothers, as they give much more guidance about upcoming profit results. Because of constant disclosure, a big company would have delivered a profit upgrade or downgrade by now if their results were to be materially different to what they had previously guided towards.
Here are the three key areas we concentrate on when it comes to financial analysis of companies, both big and small, and the ratios we examine first:
1. Balance sheet
Net debt, or debt minus cash. This tells us to what extent the group is funding its operations through credit, which it must pay back. You need to make sure that the debt is not going in the wrong direction for unexplained reasons.
If the company is investing in growth and it is clear what it's investing in, there should not be a problem. There needs to be consistency between the story the company is spinning and the numbers behind it.
People talk a lot about net debt to equity, but the most important component is net debt. Equity will not change much unless the company restructures, which is typically by raising more money from shareholders.
Working capital, or current assets minus current liabilities. This is the operating capital, or what a company needs to be in business.
If a company makes something to sell and its stock of inventory increases substantially, you need to ask whether it will be able to sell that stock.
Pacific Brands is a manufacturer of jocks and socks. If its inventory number is bigger than the market expects, the stock will sell off, based on the assumption that this number is big because it has not achieved adequate sales. It will probably have to sell stock at a big discount to clear it.
2. Profit and loss
The gross profit margin is a function of price of a good and the cost of sales. A one percentage point difference in the gross profit margin makes a massive difference to the number that shareholders focus on: the net profit after tax.
A company can be heavily affected by the level of the Australian dollar against other currencies, and by the level of competition that affects the prices a company can charge for its products or services.
You are looking for consistency between management's explanation of what is happening in these areas and the actual number.
Operating costs and/or sales growth. Operating costs are those costs that are below the line, or costs that are not related to individual sales. They include employee costs and are all the costs below the gross margin.
They also include depreciation and amortisation, which are non-cash costs of a business and relate to the need to replace the equipment needed to stay in business.
Sales growth is essential if you are buying a company on the basis that it will grow profits quickly. If you bought it as a growth stock and it's not showing sales growth, dump it.
A value stock, on the other hand, may not be showing any growth, but it has what real estate agents like to call "potential". The prize is to buy a value stock that is then recalibrated as a growth stock. You get the double-whammy effect of climbing earnings and a higher multiple. The thing to avoid is the opposite.
3. Cash flow
The cash flow from operations. The money coming into the company before accounting for investment and financing.
The key here is that the operating cash flow is in the same ball park as the accounting-based earnings before interest, tax, depreciation and amortisation (EBITDA).
The Australian telecommunications group OneTel, before going bust, showed an EBITDA profit, but its cash from operations did not come close to this figure. The reason was that it was capitalising expenses. In other words, instead of costing what it was spending, it was including them in the assets it was building. These costs would be amortised at a later date, but this did not help it pay the bills.
When a company is growing fast there might be a valid reason for operating cash flow to be significantly lower than EBITDA, because money is going into working capital. If you are a widget producer that is growing at 20 per cent a year, your trade debtors should be growing at that rate. Only when growth slows do you start seeing the cash really roll in.
Cash flow is the key. The cash flow statement is in many ways the key to investment analysis because it draws it all together. This is the one you want to concentrate on if the others do not make much sense.
If you look at a bank's balance sheet you will be lost. But the cash flow statement for even the most complicated companies is more descriptive of the actual business.
Outside of how much money the company is receiving from its business, the cash flow statement shows how much it is spending on property, plant and equipment, and investing in other businesses; and it shows how it is financing this spend, whether it's from the issue of shares or if it is raising debt capital.
If you can work this section out for one company, you can do it for all other companies in its sector.
About the author
Richard Hemming is the founder of Under the Radar Report, a popular investment newsletter on small companies. Access a free 30-day trial of Under the Radar report. Under the Radar Report will be delivering a full results analysis for the upcoming reporting season. Subscribers can check out the 100-plus small caps covered in the Research Summary spreadsheet.
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