Time flies, and we are once again on the cusp of another earnings season.
Investors, however, will be more closely scrutinising this set of numbers for clues on how businesses are coping with the twin headwinds of high inflation and rising interest rates.
Thus far, REITs such as Mapletree Logistics Trust, Suntec REIT and Frasers Centrepoint Trust have already announced their earnings.
Up next are blue-chip stalwarts such as Keppel Corporation Limited and lender United Overseas Bank Ltd.
Investors can also get a glimpse of the results for fintech business iFAST Corporation Limited and assess if a fall in demand for semiconductors is affecting technology stocks such as Micro-Mechanics .
What you want to watch out for are warning signs of deteriorating operating conditions.
If you’re wondering which aspects of the financial results you should watch, we offer four red flags you should not miss.
Revenue and net profit growth
There are growing concerns that companies will struggle to increase their year on year revenue.
These concerns are valid as high inflation, coupled with surging interest rates, has a dampening effect on consumer demand.
Businesses have two key methods of increasing sales.
The first is to sell more of a product or service while the second is to raise prices.
The latter is much tougher to do in an environment where consumers are sensitive to every little price change, but businesses that have strong pricing power, such as Apple , should pull this off successfully.
With demand falling, many companies may also see sales volume dip as customers tighten their purse strings.
As for net profit, there’s only so much a company can do to cut costs.
It’s instructive to see if these cost increases are merely temporary, or if they are here to stay.
It’s good to pay attention to management commentary on how costs are being controlled, and whether profit margins can hold steady or even recover in time to come.
Free cash flow
While profits are important, cash remains the lifeblood of any business.
Businesses may suffer from declining profits, but investors should check if they still manage to generate free cash flow.
Free cash flow is, in a nutshell, what’s left over after capital expenditures are deducted from operating cash inflow.
If a company can consistently generate free cash flow, it will not be reliant on bank borrowings to fund its operations and expansion.
Positive free cash flow is also a sign of business health and increases the likelihood that the business can weather economic storms.
Debt levels
With interest rates on the rise, a key metric that investors need to look closely at is the debt level of a business.
You need to look at whether the company can support its debt load, and the steps it is taking to reduce its debt over time.
Useful debt financial metrics include net debt to EBITDA (earnings before interest, taxes, depreciation, and amortisation) and EBIT interest cover, taken as operating profit divided by interest expense.
Such metrics allow you to assess if a business can continue to service its finance costs through operating profit and whether its debt load may be getting too heavy to bear.
It’s also useful to review the level of finance costs being paid and compare it to prior years.
The double whammy of reduced demand (i.e. lower profits) and higher finance costs has sunk many a business before.
When studying REITs, you should observe the REIT’s gearing level, its average cost of debt, the proportion of fixed-rate loans, and the interest cover ratio.
Dividend payments
A fourth aspect to review is the dividends declared by the stock.
It’s natural to expect higher year on year dividends but it’s useful to remember that businesses go through ups and downs.
Hence, dividends may not always increase in a straight line.
As dividend payments are discretionary, businesses have the leeway to reduce or even eliminate them during tough times.
However, the key is to understand the rationale behind any dividend decisions.
Dividends may be reduced temporarily to help the business to improve its cash flow or to strengthen its balance sheet in anticipation of a weak economy.
Once the economy is on firm footing, these dividends will then be restored or even increased.
Finally, you should look at the dividend payout ratio for a business.
A company that is paying nearly all of its net profit as dividends have more room to reduce its dividends should net profit fall.
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