Don’t get burned by the promise of profits

Investors are fixated on profits.

But a fantastic headline profit doesn't mean a company will keep its promise in other words, deliver some of those profits to you.

I've seen plenty of companies go into receivership despite making what looked like a decent profit.

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It's become a bit of a theme here at The Right Side: What makes a promise reliable?

In last Wednesday's Right Side, I said I'd show you how to use the balance sheet to help judge. So let's do just that.

How to use the accounts

First, you take a look at the profit and loss account. This tells you what the promise is. But never take that as a reason to invest. Go to the cash flow statement next, which will tell you whether the business is delivering on the promise. And the balance sheet tells you how reliable the promise is on an ongoing basis.

That might seem a little simplistic and there is more to finding great companies than that. But if you think about accounts in those terms, you'll have a better idea than most.

Investors home in on the profit and loss the grand promise, if you like. That's where you'll get the figures for the earnings (hence price/earnings or p/e), earnings per share (EPS) (hence dividend cover), as well as stuff like profit margins.

BUT, these are all just promises. Don't trust them...

There are all sorts of accounting rules that allow the accountants to show profits, even if they don't exist (in terms of cold, hard cash). That may be right and proper. Take a business like Ocado. They're investing tens of millions on new, state of the art customer fulfilment centres'. This cash investment will be written down in the profit and loss over many years effectively they're saying the new facilities should be expensed' over their useful life.

That means the directors are making an assumption about the useful life of their technology and facilities. And they're assuming they'll generate a useful profit out of them over the years (or else they'd have to write down the investment sooner). These are promises built on assumptions.

If you want to cut through the assumptions and see what cash is really coming through the door, then you go to the cash flow statement.

Ultimately, for the business to make good on its commitment to you, it's going to have to bring home the bacon. That means positive cash flow. Recently we used Tesco's cash flow statement to help us judge Tesco's real performance in cash terms.

But to assess the long-term reliability of the promise you need to look at the company balance sheet.

Don't put your faith in all the fancy ratios

Investors love ratios. I mentioned some of the P&L ratios earlier (p/e, EPS, and so on). When it comes to the balance sheet, you'll find more of the same. Ratios to describe the company's liquidity (how much cash is on hand) and leverage (have they taken on too much debt?) and shareholder funds.

But you shouldn't put your faith in these simple ratios. For starters, a ratio is totally meaningless in isolation. You'll have to compare it to something else and what should you compare it to?

Secondly, though there are set accounting rules, they leave room for massive distortions. For instance, a business can choose whether a property is left on the balance sheet at book cost, or regularly revalued.

A company that doesn't revalue property (Sainsbury's for instance) may have some valuable assets that don't show up on the balance sheet. This is all lost on the ratios.

Ratios can't judge subjective things like the quality of an asset. And they're limited on judging the type of debt and how dangerous it is.

Has the business borrowed £10m in long-term debt to buy freehold property, or has it gone into an overdraft to buy a fleet of vans and technology? I might be happy to lend my money to a relatively heavily indebted business with a sound asset base.

I may not want to lend to a firm that looks good (in terms of the accounting ratios), but whose assets may be dodgy. Incidentally, I mentioned Ocado earlier; I think it's a case in point. If it can't start generating some useful profits out of its massive investment spree, then it may need to make some write-downs.

In the fullness of time, shareholders may find the asset base is worth less than expected.

Know where to look

I guess what I'm really saying is that if you want to judge how reliable a company's promise is, then you're going to have to make your own assessment based on the balance sheet.

This may sound like hard work, but it really shouldn't be. To be honest, if the accounts are too difficult to fathom, then the chances are you should probably leave the company well alone.

As usual, the most pertinent details are all to be found in the notes to the accounts.

Look for the note on debt. It'll break down the debt figure into different types of borrowings like bank debt, corporate bonds, or any other. It'll tell you how much interest is payable and when the loans need to be repaid.

This is life or death stuff. How much interest is being paid on short-term debt? Anything over 8% or 9% in today's environment looks bad.

How much money will need to be repaid and when? If there's a £500m bond maturing in two years' time, then is the company likely to be able to repay it?

Then go back and look at the business assets again there'll be a note. Are you confident that the assets are good enough to warrant the debt? If need be, can the business re-finance any maturing debt on the assets it holds?

If you can answer these questions to your satisfaction, then you should feel comfortable. If you can't, then steer clear.

To assess a balance sheet takes a bit longer than flicking through some arbitrary accounting ratios. But it's a fantastic investment of time. It'll help you understand your investment and it could save you from a very costly mistake.

For more on this, it's worth checking out my colleague Tim Bennett's short tutorials on company accounts. He's done one on what profit is, one on balance sheets, and a useful intro to cash flow statements. Well worth taking a few minutes to watch these if you're keen on do-it-yourself investing.

This article is taken from the free investment email The Right side. Sign up to The Right Side here.

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