Learning about shares: Past profits useful pointers to future

Olympic champ and new investor BARBARA KENDALL continues her quest, helped by the NZX and broker Dan Dividend.

Barbara Kendall asks:

Q. I've started collecting information on companies I'm considering investing in. I know companies' financial statements hold clues, but how do I decipher them? Can you point out a couple of pieces of information that I should really care about?

Dan Dividend responds:

A. Companies put a wealth of information in their financial results, and you can feel swamped by the surpluses, liabilities, payables, accruals, cash flows, in and outflows.

I'll concentrate on after-tax profit and debt-to-asset ratio.

Although not the most important figures, these two numbers are among the first things you should swipe with your highlighter.

Let's start with some definitions.

After-tax profit

Often referred to as earnings after tax or "the bottom line", this measure shows a company's profitability at a glance. You'll find it in the statement of financial performance.

Debt-to-asset ratio

Also called the gearing ratio, this ratio shows the amount of debt a company has relative to its assets.

To calculate it, locate the statement of financial position in a company's annual report. Simply divide total liabilities by total assets.

A debt-to-asset ratio greater than 1 indicates that a company has more debt than assets. A company with a higher proportion of assets to debt will have a ratio less than 1. A company that has borrowed heavily to pay for its assets will have a higher ratio. This week's guest broker, Rob Mercer from Forsyth Barr, explains how to use these figures when deciding whether to invest in a company:

Yardstick for growth

Taken from a single year, after-tax profit doesn't tell us much at all.

However, by looking at a company's after-tax profit over, say, the past five years, it's possible to glean useful clues about the future.

Plot the numbers on a graph and think of it as a yardstick for growth. Profit that has increased steadily suggests predictability of earnings and steady growth.

Earnings that increase from year to year can also give you a feel for management's ability to increase the company's profits. This in turn tends to promote confidence in its shares.

The idea of confidence leads us to how you can use the debt-to-asset ratio when researching companies.

A company with a high ratio - that has borrowed heavily to finance assets - could be viewed as a risky investment, because the higher the level of debt, the greater the risk of financial strife if its profits fall.

However, the company might have strong confidence in its earning power based on a track record of steadily increasing profits.

In this case, high debt isn't necessarily something the market would hold against it.

When you find a company with a high debt-to-asset ratio, turn to the cash flow from operations page of the annual report.

It's really important for companies to have enough spare cash to pay interest on debt.

So, a high debt-to-asset ratio should serve as a flag prompting you to investigate a company's ability to service its debt.

Ask your NZX broker for more information.

* NEXT: What makes one company a better investment than another?

* GOT A QUESTION? Feel free to email email Dan Dividend with your questions