Read a balance sheet like a pro this reporting season

Once again, the time is upon us for Australian companies to share their deepest darkest secrets financials for the year, offering a snapshot of how they are performing and their strategic direction going forward.

It can be a volatile period.

Disappointing news can see a company’s share prices plummet, unexpected positives can see it rise. Of course, sometimes the market barely responds – even if the news is bad.

It can feel like an inundation of news – so what data should you actually pay attention to?

What to focus on in the annual report?

An annual report from a company will have a variety of information, including a letter to shareholders, management discussion of performance, financial statements and data and might also include other relevant details, such as audit reports or specific research relating to a product or asset.

It can be a lot to take in, so your goals in reviewing the annual report include:

• Assessing the financial health of a company
• Understanding the company’s long-term viability and potential for ongoing growth
• The investment thesis for your portfolio (be it whether it still merits a position if you already hold it, or might merit a position in the future).

From that perspective, flicking to the financials is a good starting point.

Here’s how you can answer some of your key questions about the financial health of a company.

1) Is the company profitable?

You might see Revenue referenced but that’s not the full picture of profitability because it is all earnings before expenses. Look at the Net Profit for the company which gives you what the company is left with after paying its expenses. Net profit can also be listed on the balance sheet as NPAT (Net profit after tax) or NPATA (Net profit after tax and amortisation). 

Earnings Per Share (EPS) is also useful as it allocates profit per individual share. If a company pays Dividends, this can also be a sign of financial health and management confidence – be warned if the dividend looks particularly high against the share price, this can be a sign of challenges.

2) Can the company service its debts or is it over leveraged?

Look at the Current Liabilities in the financial statement which covers items like loan payments due within the year or expenses like unpaid wages, along with Long-Term Liabilities which covers bonds and loans payable over more than one year, along with long-term leases and rentals. 

Also consider looking at Operating Cash Flow and Capital Expenditure to help you understand what cash is available to the business after paying for its daily operations and liabilities. Ideally, you want to see operating cash flow higher than the net income of the company.

3) Can the company continue to grow?

Looking back to profit and liabilities is part of making a judgment on the ability of a company to keep growing. Some analysts also view an increase in dividends as a sign of management confidence in the future – while stopping dividends can be a negative. 

Looking at capital expenditure, in particular on Research & Development (R&D) can be interesting, particularly if you look to management discussion on what the spend actually entails. For example, strong spend on R&D in a tech company to enhance existing products and develop new ones could bode well for a company maintaining its competitive position and continuing to grow profits. 

You can also look to the shareholder letter, director’s reports and management discussion for forward guidance on the business on new developments, goals and business targets.

4) Does the company still meet my strategy/investment thesis?

This is typically a personal qualitative decision based on a combination of the data above and looking closer at the industry the company operates in and how that company compares to its peers. It is also worth revisiting your strategy and how a company fits within that strategy.

While the above can give you some general starting points to look for in an annual report, each industry and sector has specific metrics that will give you important information about how a company is competing in its sphere. Some examples include premiums for insurance companies or production volumes for miners. 

Livewire’s Chris Conway has a detailed checklist of the metrics for each industry you can find here or you can find his discussion on themes to watch this reporting season in this article.

Understanding beats and misses

Reporting season is full of beats, misses and ‘inline with expectations’. If you are unfamiliar with these terms, it simply refers to consensus expectations for a company’s earnings set by professionals and how a company performs against this.

A company’s share price performance post releasing annual reports can often be more influenced by how it compares to these expectations than whether it has demonstrated profitability. For example, an earnings miss might see prices fall in the short term, while a beat might see prices rise.

Beats or misses might tie into the investment case for a company and in some cases, an analyst might revisit their projections for a company after results.

When to buy or sell

Sometimes reporting season can create opportunities to buy or sell companies – particularly in short term volatility post result releases.

A caveat rather than simply buying into market noise is to revisit the basics.

If you plan to sell…

• Is it to crystallise gains to reinvest in other parts of the portfolio and is it still worth holding some (or all) of your existing holding as part of your strategy?
• Is poor performance short-term and if so, does the stock still meet its investment thesis and your investment strategy? If so, you may not wish to sell.
• What impact does selling have on your portfolio? (i.e. crystallising gains or losses and what does that mean for portfolio performance and tax implications)

If you plan to buy…

• Does the company meet with your investment strategy and fit within your portfolio?
• Have you considered the company valuation and do the fundamentals justify the price you might be paying for the stock?

Reporting season is coming

You can find the dates that Australian listed companies release their annual reports on the ASX website. 

On the day a company releases its reports, you’ll be able to find the reports, ASX statements and investor presentations on its website in the investor sections. 

You can also find more information and interviews with fund managers on the results for some of the most popular stocks Livewire readers invest in across August on Livewire Markets. Stay tuned for more!