KEY POINTS:
Cash is king when it comes to reading a company's financial accounts, say the experts.
The cash flow statement is one of the first things to look at, says Mark Lister, head of research at investment advisory house ABN Amro Craigs.
"We look at the profit and loss statement, and then we look at the cash flow statement and say, well, theoretically the operating cash flow and so forth should tally up fairly evenly with what we're seeing on the P&L, and if doesn't then there's a problem.
"You can't say, 'We made $20 million this year but we only had $2 million of cash flow' - that raises an alarm bell. It suggests, have you got some sort of credit control issue where you're not collecting money fast enough, and does that point to some potential bad debts where you might not actually get that money at all?"
PricewaterhouseCoopers partner Michele Embling agrees.
She points out that in the notes to the consolidated financial statements, which will be included in a company's annual report, the business is actually required to reconcile profit and loss with how much cash was generated.
Another thing to look for is the company's debt ratio, the experts say. The New Zealand Shareholders Association considers a company with a debt to assets ratio of anything over 50 per cent to be highly geared, or highly indebted.
Lister says a debt ratio of around 30 to 40 per cent is acceptable, but it depends on the company - a utility such as lines company Vector, for example, could afford to carry more debt because it has a very stable and predictable cash flow.
However, he says that in the current environment debt is out of fashion, with the market favouring companies with low or even no debt levels. "At the moment debt's so hard to come by, at reasonable prices that is, that anyone that's got above average levels of debt - levels of debt that under normal circumstances would be considered normal - are being looked at quite negatively at the moment, because the refinancing costs can be huge."
When it comes to dividends, investors need to be looking to the future, Lister says. "A high dividend yield is wonderful but it can point to concerns from the market that earnings are going to decrease in the short term. It's really the yield five years out that we should be focusing on."
PWC's Embling says investors should always be considering what the company might do in the future, and much of the information necessary to take that view is in the notes accompanying the financials. For example, under new International Financial Reporting Standards a company has to note down "critical accounting estimates and assumptions".
"The idea being that the financial statements should highlight where management had to use their judgment in coming up with the number."
If a company has goodwill on its books, it now has to test whether it is still worth what it was last year. It does this by doing a cash flow projection, and it has to list the assumptions it has used in making that projection.
This allows the investor to decide for themselves whether they think the assumptions are fair, she says.
Another new element to be found in the notes is an explanation of the company's liquidity risk. "This gives you an idea of how the company is financed, and how much of it is going to have to be repaid in a year and say refinanced, or how much of it is actually long-term borrowings."
