Peter Hodson: Understanding quality, reliability of a company’s reporting essential for making investment decisions
Published Apr 20, 2023 • Last updated 5 days ago • 4 minute read
A company’s financial statements provide a snapshot of its financial health. Photo by Getty Images/iStockphoto With a recession coming for sure (or maybe not for sure), it is time to get back to basics. We like to start any look at a stock by examining the company’s accounting because there are several key areas that provide a clear picture of its underlying financial health.
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Access articles from across Canada with one account. Share your thoughts and join the conversation in the comments. Enjoy additional articles per month. Get email updates from your favourite authors. Accounting is the process of tracking and reporting a company’s financial transactions, and it is essential for investors to understand the quality and reliability of a company’s reporting before making investment decisions.
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The first place to start is a company’s financial statements, which provide a snapshot of its financial health. Here are the five main things to examine.
Three big picture items First, the income statement shows a company’s revenues and expenses over a specific period. It provides a summary of a company’s financial performance and its ability to generate profits. Is your company profitable? What is the trend on margins? Taxes?
Second, the balance sheet provides a snapshot of a company’s financial position at a specific point in time. It shows the company’s assets, liabilities and equity, and provides insight into its financial health and ability to meet its obligations.
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Third, the cash-flow statement shows how a company generates and uses cash over a specific period. It provides insight into a company’s ability to generate cash from its operations, invest in its business and pay dividends. Look at the operating cash flow first to see if the company’s business actually generates cash. Then look at financial and investment cash flows. Was the company financed by debt or equity? Did it buy back stock or invest in new assets?
Accounting policies These are the rules and procedures a company uses to prepare its financial statements. Investors should carefully examine these policies to understand how the company records and reports its financial transactions.
One area to pay attention to is revenue recognition, which refers to the timing and method of recognizing revenue on the income statement. It is important to understand how a company recognizes revenue to ensure it is not manipulating its financial results, such as recording revenue too early when there are generous return policies.
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Article content Another is depreciation and amortization, which refer to the method a company uses to allocate the cost of its assets over their useful lives. Investors should understand these policies to ensure they are consistent with industry norms.
Inventory accounting, or how a company values its inventory, is a third key area. Investors should examine a company’s inventory accounting policies to ensure they are conservative and that the company is not overvaluing its inventory.
Quality of earnings This refers to the sustainability and reliability of a company’s profits. Investors should examine a company’s earnings to determine if they are of high quality. A company with consistent earnings growth over several years is more likely to have high-quality earnings than a company with erratic earnings. And a company with positive cash flow from operations is more likely to have high-quality earnings than a company with negative cash flow.
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Article content Also, a company with a high return on equity is more likely to have high-quality earnings than a company with a low return on equity. And investors should remember that many companies do not pay much in taxes when they are growing, so it is important to know how earnings will change once a company becomes cash taxable.
Debt and leverage These metrics can have a significant impact on a company’s financial health. Investors should examine a company’s debt levels to determine if they are sustainable and manageable. Areas to pay attention to include the debt-to-equity ratio, which measures a company’s debt relative to its equity. A company with a high debt-to-equity ratio may be more vulnerable to economic downturns and may struggle to make debt payments.
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Article content The interest coverage ratio, which measures a company’s ability to pay interest on its debt, is another key. A company with a low-interest coverage ratio may struggle to meet its debt obligations.
Also look at the maturity of a company’s debt, or the time frame in which it must be repaid. A company with a large amount of debt maturing in the near term may face liquidity issues. We always look at the debt-maturity schedule, which is typically revealed in the financial notes, which leads us to …
Financial notes It is surprising how few investors read the notes in a financial statement. Sure, they can be boring and confusing, but they really do contain the best information and sometimes even hidden messages, either good or bad. We are reading the notes very carefully these days, looking for a company’s exposure to higher interest rates, rising costs and potential other bombs if we enter a recession.
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Article content 5 things about investing I wish I had known in 1985 5 burning questions investors have right now 5 investor tactics and behaviours I wish I could figure out The notes will also provide further details on all the points we’ve noted above, and go into more details on line items. The notes are likely more important than the rest of the financial report, so we often start with the notes first when examining a company for investment.
Peter Hodson, CFA, is founder and head of Research at 5i Research Inc., an independent investment research network helping do-it-yourself investors reach their investment goals. He is also portfolio manager for the i2i Long/Short U.S. Equity Fund. (5i Research staff do not own Canadian stocks. i2i Long/Short Fund may own non-Canadian stocks mentioned.)
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