What to look for within the commentary & numbers this reporting season

Reporting season, that eight week period when listed companies fess-up' their earnings – is upon us again. During this bi-annual 'look-see', you should get the 'full Monty' on how good, bad or otherwise the previous six months was and what's in store – so it's important to pay attention.

With consensus estimates now pointing to a 6% fall in earnings per share (EPS), investors will be looking beyond the blue-chip stocks for good news stories. This is why it's important to look beyond the numbers and focus on the underlying commentary.

Fresh numbers that surface as reporting unfolds can and will have a significant impact on the long-term value of the stocks you own. But you need to know what to look out for, and this is where many investors come unstuck.

One of the best ways to get a quick fix on the quality of a company's balance sheet is to check out key performance measures. These include debt levels, cash flow ratio, net-debt to equity, earnings per share (EPS) and return on equity (ROE) growth, and the strength of its cash flow relative to reported profits.

Here are 6 tips to help you separate the numbers and supporting commentary from the spruiking of those good news stories that often accompany reporting season.

  1. Have an idea of what you're expecting from a company 'before' it reports so that you're in a much better position to determine whether the result was good or not. Read the financial statement 'before' the supporting commentary. If there's no mention within the commentary of certain key numbers, it's probably not a good sign – so you'll need to investigate. Remember, Australian accounting standards allow for significant wriggle-room when it comes to 'playing' with the figures on their balance sheet. It's also important to understand most companies would dearly love you to focus your attention on earnings before interest and tax (EBIT), and often strip out charges deemed non-operating.
  2. Compare how a company presented its report in years past. If numbers that used to be presented aren't any more, it's not a good sign. As a case in point, a few years ago, medical device maker ResMed (ASX: RMD) stopped reporting the movement in average selling price, which was no longer flattering. Then there's Fortescue Metals Group (ASX:FMG) which by moving interest expenses from operating cash flows to financing cash flows, makes its free cash flow appear a lot better than it is. Given that 'period-V-period' profit falls can be misleading, especially within the resources sector – where massive commodity price falls can lead to spectacular drops in profitability – it's also critical that you offset that against management's future outlook.
  3. Examine how well cash has been flowing through the business, and check to see whether profits and cash flow are broadly in sync, if not – find out why. Check to see if a company has a 'funding gap'. This occurs when there's insufficient cash to continue operating and the company is forced to take on debt or raise capital from shareholders. Generally speaking, the greater a company's funding gap, the less likely it is to expand its business, pay (sustainable) dividends and withstand any economic downturns. 
  4. Check whether the type of business and its level of expenditure complement the way it chooses to report to the market. Remember, profit is an accounting number, so you need to understand what's excluded from underlying earnings. For example, a P/E valuation is more meaningfully applied to companies with an established history of consistent earnings that are indicative of normal cash flows the business earns. The same is true for another ratio like net tangible assets (NTA) which is an accounting rule (not a market value). So looking at NTA in absolute terms can be misleading, especially when to comes to listed REITs (real estate investment trusts).
  5. Find out what management is doing for the long-term good of the business. There's a swag of companies that need to explain how they're going to take the business forward, these include the big-four banks, BHP (ASX: BHP), Adelaide Brighton Ltd (ASX: ABC), Woolworths (ASX: WOW) and Suncorp Group (ASX: SUN) to name a few. Does the company have a history of poor disclosure and why? Be on the lookout for companies that perennially need to satisfy a 'please-explain' to shareholders. As a case in point, six weeks after Chairman Margaret Jackson advised investors to expect full year 2016 results to materially exceed the FY15 results, cleaning and catering giant Spotless Group Holdings (ASX: SPO) released an about-face trading update to the market – which  saw the share price nose-dive by a whopping43%. Then there was the infamous mining services company, Forge Group (ASX: FGE) which bungled disclosure over write downs, and the level of financing required to fulfill questionable contracts.
  6. Check how management is responding to its problems. To its credit, Suncorp is throwing a lot of light on to how it plans to recover former insurance trading ratio (ITR). But BHP and the big-four banks need to provide sufficient insight into where future growth will come from. You need to check for guidance on dividend policy and pay-out ratios. Take a close look at the balance sheet and the quality of a company's cash flow to decipher whether a dividend looks sustainable or not, and look to the commentary for meaningful clues.