FEBRUARY REPORTING SEASON IS COMING
By Denise Slattery
Next week sees the start of the February Reporting Season. During the month of February, more than 100 of Australia’s most well-known companies will be releasing their earnings results for the first half of Financial Year 2018 and providing an update on their performance to the market.
Understanding how balance sheets and profit and loss statements work, as well as some financial ratios, can help your understanding of the business and assist in making informed investment decisions. This email provides a brief explanation of some of the reports and financial ratios that companies will discuss when presenting their updates.
As a shareholder or would-be shareholder, it’s important to know as much as you can about a company’s financial health to inform your views about its potential to perform in line with your expectations.
The Balance Sheet
A balance sheet is also called the statement of financial position. It outlines a company’s assets, its liabilities and its shareholders’ equity at a point in time.
The balance sheet always follows the following formula:
- Assets (what the company owns) = Liabilities (what the company owes) plus Shareholders’ Equity (the amount of money invested by shareholders plus retained earnings available after all company debts are paid)
The profit and loss statement
A profit and loss statement is also called an income statement, or the statement of financial performance. It measures how the company earns its revenues and incurs its expenses during a period and, importantly, shows the company’s resulting net profit or loss.
What are financial ratios?
Financial ratios involve the comparison of various figures from the financial statements in order to gain information about a company’s performance. Financial ratios can be a useful tool for investors because they allow for easier comparisons between companies, across the various sectors of the market.
With all ratios, however, there are some traps to be aware of and most investors would want to consider a number of different variables on which to base buy or sell decisions.
A market ratio is one that relates a company’s financial situation to its shares to provide some insight into the value of the shares. Below are two examples:
Earnings per share (EPS)
- EPS = Net profit available for ordinary shareholders divided by the number of ordinary shares in the company
Earnings per share (EPS) is the portion of a company’s profit that can be attributed to each ordinary share in the company.
EPS can be useful in looking at whether a company is growing its earnings from one reporting period to the next, although it is also important for an investor to look at the reason behind the growth or contraction.
Price/earnings ratio (P/E)
- PE = Current share price divided by Earnings per share
A P/E ratio shows how the market price of a company’s shares relates to its earnings per share. In other words, it represents the amount of money investors are willing to pay for a share in the company’s earnings.
The higher the ratio, the greater the amount that an investor is willing to pay for current earnings. So a share with a high P/E is generally expected to increase in value or could be considered expensive.. A share with a low P/E may already be a mature business or it may simply be undervalued. The long-term trend for the price/earnings ratio of the Australian market is usually said to be a ratio of around 15.
While a higher P/E ratio may mean a stock looks expensive, what investors are willing to pay for a share generally comes down to views on what will happen to the earnings of the company in the future. So it’s often necessary to probe slightly deeper and ask why a P/E ratio is where it is.
Companies typically run into trouble when they are low on cash. Liquidity ratios show how well a company could cover the payments it’s required to make.
One example of a liquidity ratio is the current ratio, which shows a company’s ability to repay short-term debts quickly were it to get into trouble.
- Current ratio = Current assets divided by current liabilities
Regardless of the environment, an investor would probably be looking for a current ratio of at least 1, which indicates that in a worst-case scenario the company would at least be able to pay its most pressing debts.
Analysts will also typically be interested in what is included within current assets, the details of which should also be found within the notes, to double-check that this isn’t overweighted to something like inventory that a company could conceivably struggle to convert to cash under pressure.
These typically look at both the profit and loss statement and the balance sheet to show a company’s ability to use the assets and borrowings it has in order to make a profit.
Return on equity (ROE)
An example of a profitability ratio is return on equity, which measures how well a company is using the money shareholders have invested to generate a profit.
- Return on equity (ROE) = (Net profit divided by Shareholders’ equity) x 100
A company will often highlight its return on equity in its financial report.
Some industries will naturally be predisposed to have a higher return on equity than others, depending on the amount of large assets required before they can generate a profit. Because of this, ROE is best used to compare companies that operate in the same industry.
There are also things a company can do to impact ROE – such as a buyback, which would typically give ROE a bump as the profit would be divided by a smaller amount of equity.
Looking at a company’s financial statements and financial ratios is a useful tool to assist you to make an informed decision as to the type of companies that you may wish to consider for investment.
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