The number of Australian listed companies deemed to be exposed to manageable levels of financial risk has improved from 27.5 per cent to 28.2 per cent over the year to March 2017. But more than 70 per cent are still exposed to unacceptable levels.
This can be symptomatic of the ASX having many of its constituents in start-up phase, where capital raisings are required to keep an idea alive. But these statistics are one of the reasons our market is often perceived as high risk by global investors.
At Lincoln, we conduct a diagnosis of the financial health of the Australian sharemarket after the end of each reporting season.
Using our proprietary Financial Health score first developed by our founder Dr Merv Lincoln, we dissect every company on the exchange and identify their risks.The health score has correctly identified 94 per cent of all corporate failures since 1984 as unhealthy before their collapse.
If you are an ASX investor, this analysis is essential. Without understanding the true financial health of the companies in your portfolio, you are speculating and risking loss.
One of our key ratios is the total liabilities to total tangible assets (TLTAI). It measures the gearing level of a company and analyses the relationship between debt and equity with regards to funding a company’s asset base. The higher the number, the higher the risk.
When looking at TLTAI, it is not surprising to see that, in line with the improvement in the overall health of the market, 60.9 per cent of companies have a ‘‘strong’’ or ‘‘satisfactory’’ TLTAI versus 59.3 per cent 12 months ago.
Some may perceive these numbers as counter-intuitive given that 60.9 per cent of companies have low/manageable debt levels yet only 28.2 per cent of companies are healthy.
This low debt level is often the result of many companies on our exchange not being profitable or generating positive cash flow. These businesses are often found in the exploration mining sector as well as healthcare/pharmaceutical businesses in trial or start-up phase. With no cash or profits, it is only natural that banks will not lend them money. Therefore they tend to have lower debt levels.
With many high-risk companies possessing low debt, we turn to one of our cash flow ratios OCFCL (operating cash flow to current liabilities) to make sense of the overall result. OCFCL measures the ability of a company to meet its short-term commitments from internally generated cash flow. The higher the value of this ratio, the lower the level of risk.
Despite the slight improvement over the year, these numbers reinforce our view that cash is king when it comes to running a sustainable business over the long term, particularly those among the 39.1 per cent that have stretched the balance sheet (TLTAI ratio) a little. Notwithstanding the immediate risk of insolvency, there is the ongoing risk of companies tapping investors for more money.
Participation is mandatory to avoid diluting your original holding.
These statistics are designed to raise concern as well as soothe investors.
We don’t name and shame unhealthy businesses in a public forum as we want listed companies to succeed for the benefit of investors. But knowing the true level of financial risk your stocks are exposed to before you invest in them will help you avoid future failures like Arrium and Dick Smith that lead to stress and financial loss.
Published Wednesday 26 April 2017
www.afr.com | The Australian Financial Review