How to interpret financial results

You should be able to assess the health of a company by looking at certain key indicators from their financial results.

All companies listed on the Johannesburg Stock Exchange are required to issue financial results twice a year ‒ interim results and annual results. While it takes a cohort of accountants, auditors and executives to produce these results, as an investor, or someone interested in how a company is doing, there are a few key indicators that you can review in a few minutes to understand the company’s financial results.

Absa interim financial resultsHeadline earnings per ordinary share (HEPS)

In other words: How much money is it making?

This tells you how much money the company has made for shareholders. This figure is represented by taking the profit of the business and dividing it by the number of ordinary shares in issue.

These earnings are based only on the operational and capital investment activities. It excludes any income or expense that may relate to once-off activities such as staff reduction or the sale of assets. If the company laid off a significant number of employees and had once-off retrenchment costs, those would be excluded from headline earnings. Accounting write-downs for a restructuring such as Absa unwinding from Barclays would also not be included in headline earnings.

Headline earnings allow you to compare like for like across companies as it avoids once-off corporate activity which could over-inflate or under-report the actual profit made by the operation.

Why it matters: Apart from stating how much the company has earned, a comparison to last year’s earnings will indicate if the company is growing. By illustrating the earnings per share, shareholders can understand the earnings in relation to their shareholding and the company share price in terms of valuations.

Return on equity (ROE)

In other words: Is the company turning investment into profit?

ROE is a measure of the profitability of a business relative to its equity. This equity refers to ‘shareholder equity’ and the company’s reserves from previous profits retained by the business. This is not to be confused with the investment return based on the movement of the share price. (Share price returns are a function of the price someone is prepared to pay for shares already in issue – those will be influenced by various factors including the profits, dividends and outlook.)

You will find shareholder equity on the balance sheet. It is the actual capital the company received from shareholders prior to listing or any subsequent capital raisings.

Shareholder equity can only be increased from subsequent capital raising which usually requires the issuing of new shares which can dilute the shareholding of existing shareholders.

Shareholders may have sold their initial investment in the company to a new shareholder in the listed market, but it does not affect the value of the shareholder equity.

Why it matters: ROE is a measure of how well a company uses investments to generate earnings growth. An ROE of 30% means the company made a profit of 30c for every rand invested. The higher the ROE, the more profit the company can generate for every rand invested in it.

However, one needs to be aware that a high level of debt can artificially boost the ROE as the cash injection from a loan could inflate the number. Analysts would also consider ROA ‒ the return on net assets (assets less liabilities/debt) ‒ to get the full picture of the actual effectiveness of management to grow the company.

Impairments

In other words: Has it made any poor investments?

An impaired asset is when an asset held by the company decreases in value. This can occur when an investment by the company does poorly and it is worth less than the value on the balance sheet. In the case of a bank that could also relate to its credit book, if for example collections are lower than expected and there are write-offs.

Why it matters: While the asset value may not affect the company’s earnings, it indicates a reduction in the value of the company’s net assets and therefore impacts the value of the business.

Total income

In other words: How does it make its money?

This relates to all income earned by the company. Depending on the type of business, income would be generated from different sources. In the case of a bank, income would include fee income and interest income. Companies with investments in other businesses would include dividends or income from those investments.

Why it matters: This shows how much money a company is making and provides a comparison to previous years to see if it is growing its income. By understanding the sources of income, you can assess its areas of growth or any risks it may be facing in a changing economy.

Cost-to-income ratio

In other words: Is it keeping costs under control?

This shows how much it cost the business to generate that income. Just because a company is generating an income, doesn’t mean it is profitable. This is a key metric for a bank to understand the cost of staff, branches and IT systems to generate that income. If a company’s income is under pressure, it will look at ways to reduce costs.

Why it matters: This will tell you whether a company is managing its costs effectively and whether it can grow its earnings sustainably. A company that has a high cost-to-income ratio may need to find ways to cut costs, so look for indications of restructuring in its annual report.

Cashflow

In other words: Show me the money

Cashflow is the actual cash generated and spent by the company and not just accounting entries. Cashflow is shown as cash from operations, cash from financing (borrowing) and cash used for investing either by acquiring businesses or investing in the company’s own fixed assets.

Why it matters: Cash in the bank is irrefutable and cannot be fudged by fancy accounting. Given the Steinhoff debacle, actual cashflow is important. The free cashflow after capital expenditure indicates how much cash the business requires each year to keep operating, whether they have enough or will need to come to the market to raise more capital.

Dividend per ordinary share

In other words: Does it reward shareholders?

Dividends are a portion of the profits paid out to shareholders. A company will first consider the reserves it needs to fund the business and potential investments it wishes to make. It will then issue dividends from funds they do not need to retain. Companies in a high growth phase which are still capital intensive may pay out a lower dividend than a more established business.

Why it matters: Dividends are a critical part of the total return for shareholders. While shareholders may hold shares because they hope to sell them for a profit in the future, many invest for the income stream provided by dividends. Dividends can also indicate a healthy cashflow.

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