ASX reporting season can feel like Christmas. Opening the ASX share's report could be like unwrapping a present. A very detailed, complex present where people have expectations about what's in the present. And if the present isn't as good as hoped, the market throws a hissy fit.
Which part of the report are we meant to look at first?
There are three financial statements that a company reports – the balance sheet, the profit and loss (also called the income statement), and the cash flow statement.
Each of those statements is important, and Atlas Funds Management has given its take on which one investors should focus on.
Cash (flow) is king
The fund manager, and many other investors in the past, have suggested that companies are able to manipulate the profit and loss statement if they want to make the result look better than it actually was such as recognising revenue early, delaying spending on essential products and services, or depreciating a cost over a longer-term timeframe than what's needed.
Atlas noted that the ASX share's "cash flow statement shows a picture of the actual cash flowing in and out of the company over the past six months and is generally harder to manipulate than the profit and loss statement".
When looking at company results, the first thing that Atlas does is look at the cash flow statement and compare the operating cash flow to the net profit. If there is a significant difference between the two, it may mean that the company could be using "aggressive accounting techniques to inflate reported profits that are not backed up by actual cash flows".
The fund manager gave an example from the past of the aged care sector where it had been reporting "robust profit growth" but the cash flow statement showed that the company's growth was "haemorrhaging cash and borrowing to pay the dividend"!
Investors still need to be wary
However, Atlas warned that even the cash flow statement can be manipulated during ASX reporting season where businesses can capitalise on operating expenses as an asset. This would convert a cost, or outflow, of cash on the cash flow statement into an asset on the balance sheet.
ASX shares can still 'boost' the cash flow statement by selling accounts receivable (money owed by customers) at a discount to face value, or by delaying payments to suppliers.
Atlas pointed out that while doing something like that can improve the cash flow statement, it can be spotted with "abnormal changes" to working capital on the balance sheet.
The fund manager pointed out that companies can delay capital expenditure, but assets have to be maintained, otherwise, they deteriorate. Atlas likes to check whether the capital expenditure on the cash flow statement is similar to the depreciation charge on the profit and loss statement. A large mismatch "often warrants close investigation".
Atlas finished with these thoughts:
Earnings misrepresentation is difficult for investors to detect from the publicly available accounts, but when revealed can have fairly extreme results for a company's share prices. Printing these three statements and reading them side by side can often reveal signs of problems that a company could have or could be minimised or ignored when management presents their results to the market. As a result of bitter experience, I look at the cash flow statement first, as profits can be manipulated, and companies with great – albeit illiquid – assets can still become insolvent without the cash flow to service debt.
