Unbeknown to many investors, due to fancy balance sheet footwork, many stocks are legitimately allowed to mask more meaningful signals of distress on their income statements.
Given that reporting season is now upon us, you need know to what "wriggle room" Australian accounting standards allow for ASX-listed companies to play with the figures on their balance sheets.
Market Index has unearthed some key issues for you to consider.
A common way companies try to hide the impact of financial leverage is through the old chestnut of focusing investor attention on earnings before interest and tax (EBIT), and often stripping out charges deemed non-operating.
Equally common is the practice of moving line items within a company's cash flow statement.
The net effect of moving interest expenses to financing cash flow is that cash flow from operations can appear decidedly better than it really is.
Then there's the art of making a balance sheet look better through the off-balance-sheet leverage of minority shareholdings in associate companies.
By entering operating leases than are paid as an annual expense to use property and equipment, a company's balance sheet understates its true debt.
By only owning 49.9% of a business, which may carry a lot of debt, companies are not obliged to include it on balance sheet, and a lot of leverage can be disguised within its consolidated reporting.
If there's an enormous difference between operating earnings and bottom-line earnings or net profit after tax (NPAT), you need to find out what it is and why?
As a case in point, by moving interest expenses from operating cash flows to financing cash flows, companies like Fortescue Metals Group (ASX: FMG) have in the past been able to make free cash flow appear a lot better than it really is.
Remember, Fortescue's debt is denominated in US dollars, whereas the iron ore price is arguably driven by the cost bases of producers that are domiciled in emerging markets, which creates somewhat of a currency mismatch.
Remember, what typically pushes companies into financial distress isn't a solvency issue per se but one of liquidity – aka their inability to meet day-to-day requirements.
Hence, the problem for Fortescue and others is that if the iron ore price falls below a certain level, cash flow could turn negative, and this could start to deliver liquidity problems. Clearly this isn’t an issue right now, but it’s something to be mindful into the future.
Adding insult to injury, when times turn bad, management is forced to sell assets at depressed prices or issue new dilutive equity.
Over the last few years, a lot of highly indebted companies have been saved by low interest rates. But as the Federal Reserve constantly reminds the market, these days are over, and the Reserve Bank (RBA) is expected to start echoing similar sentiment on Tuesday 1 February.
If interest rates were to go up [5 percentage points], a lot of indebted companies would suddenly reveal just how illiquid they really are.
What’s also provided artificial relief for highly indebted companies - especially during the worst of covid – was "covenant waiving", which is tantamount to a corporate lifeline.
Interestingly, while stocks are required to release their maturity dates, no register exists, and companies aren’t exactly going to broadcast these dates any more than they have to.
If all you want to do is trade price momentum, go ahead. But if you want to invest in an underlying business, you need to look at fundamentals.
Reporting season is an ideal time to run a ruler over any stock.
Alarm bells should resonate if a company displays any of the following:
No surplus cash: This is calculated by subtracting the capital expenditure, investment and dividends paid from the company's cash flow generated from operations for the recent historical year.
A company without any (or insufficient) surplus cash is not one you want to be invested in.
Net debt-to-equity greater than 70%: This measures the financial leverage of a company. Ideally, quality stocks should have a minimum of four times their interest bill covered by their cash flow.
Historical return on equity of less than 10%: This is a gauge of past profitability, and quality stocks should have a track-record of generating at least 10% return on owner's equity.
Forecast return on equity of less than 8%: Within the current low-earnings environment, good stocks should be delivering at least high-single-digit profitability.
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