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3 things professionals look for when analysing profit results that retail investors miss

It’s always a good idea to scrutinise a company’s accounts and profit results before deciding to buy or sell an ASX stock, particularly those in the S&P/ASX 200 (Index:^AXJO) (ASX:XJO) index.

But many retail investors do not look beyond the headline figures of sales and earnings and that’s a mistake as these numbers do not tell half the story.

There are a number of figures that analysts go digging for and there are three in particular that I believe all investors should pay special attention to as we head into the next profit reporting season.

These “hidden” numbers are easy to calculate and can often explain contrary movements share prices on the day management hands in their earnings results.

This means working out the hidden numbers are relevant to short-term investors as much as those looking to build a retirement portfolio.

Why you need to pull out your abacus

You probably have seen ASX shares fall despite strong profit and sales results and vice-versa. Digging below the highlighted earnings and revenue numbers can shed light on the market reaction and provide insights into whether a stock is oversold or overbought.

The three metrics you should also be looking at are listed below. The list isn’t meant to be exhaustive but these are the three that I find most useful when examining a company’s accounts.

The other thing to note is that these measurements are generally useful to companies that make a profit. This means you probably want to use other yardsticks when looking at microcaps and other emerging stocks that have yet to successfully commercialise their products or services.

Three hidden figures you need to calculate

  • Cash Conversion Ratio

This ratio compares the cash a company receives to the earnings it’s reporting. Many might think the numbers are the same, and in many respects a good company will report very similar numbers, but in reality, most companies collect less cash than they report as profit.

There are several plausible explanations for this but the golden rule of thumb here is a ratio of 1:1 is most desirable.

To calculate this ratio, you use the operating cash flow number from the company’s cash flow statement and divide that by its operating profit, such as its earnings before interest, tax, depreciation and amortisation (EBITDA).

If the company generates an operating cash flow of $80 million and reports an EBITDA of $100 million, the company will have a cash conversion ratio of 80%.

As I mentioned, very few companies I’ve covered have 100% and even 80% is hard to find.

One reason for this is that some companies are allowed under the accounting rules to recognise profit before it collects the cash from its client.

Other reasons include an increase in working capital that may stem from a ramp up in the business.

Whatever the reason, you should be wary (or at least be asking management more questions) of those with a low ratio. There isn’t a hard and fast rule as to what constitutes a low ratio as this varies between sectors, but typically anything below 80% should be scrutinised more closely in my view.

  • Operating Margins

This should be a no-brainer figure to watch but you’d be surprised at how many investors overlook this.

Those that don’t often do not know how to calculate the margin or figure out which earnings number to use.

My preference is to divide the EBITDA number by revenue to get the EBITDA margin. I exclude any sales that are not generated by the company’s ongoing core offering.

As with the cash conversion ratio, the higher the number the better, although what constitutes a strong margin will depend on the industry.

From that perspective, it is important not to just look at a company’s latest margin in isolation. You should compare it with what its nearest competitors are making and note if the margin is increasing or decreasing.

Quite often I find this explains why a stock is being sold off even in the face of good revenue and profit growth. Sales could be increasing but if profits aren’t keeping pace or rising more quickly, it can be an early sign of trouble.

  • Significant Changes

The third thing that’s worth doing is scanning a company’s balance sheet, cash flow statement and profit and loss statement to see if there are any significant and unexplained movements between the latest period and the previous period.

ASX-listed companies will typically reproduce the previous period’s accounts in the current period’s report, which will make comparing the figures easier.

If I see a notable increase or decrease in any of the line items (such as provisions, debt, cash, etc), it will prompt me to look for an explanation before I decide whether to buy a stock.

Again, there are legitimate reasons for a significant change. For instance, a business gearing up to meet a surge in customer demand is likely to report an increase in inventories and a drop in cash.

However, it’s the changes that you can’t work out that you need to be wary of as this can often indicate an issue bubbling under the surface.

Happy investing my fellow Fools!

Motley Fool contributor Brendon Lau has no position in any of the stocks mentioned. The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.

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