Nick Anderson, member of the IASB, discusses corporate performance and how investors seek to understand the quality of the profit number, not just the amount of earnings.
How much capital has the business deployed to generate this level of profit? How persistent are earnings likely to be into the future? Does net profit include gains or expenses that are unlikely to reoccur? Is the pattern of future profits likely to exhibit volatility or cyclicality? To what extent are profits supported by cash flow generation? What are the long-term risks faced by the business, including material environmental and social factors? Investors are likely to consider all these questions in their assessment of the sustainability of future profits, drawing on the audited financial statements, management commentary and multiple other information sources.
Most long-term investors will analyse the return on investment a business has generated over a number of years and consider whether this can be sustained into the future. Likely developments in the competitive environment and related opportunities for reinvestment are a particular focus. What are the opportunities for further capital deployment and what is the likely return on this capital? Does the business generate sufficient cash flow to take advantage of these opportunities? Is the financial structure appropriate given the inherent risk profile of the business?
Many investors also seek to understand changes in a company's financial liabilities that are not cash flows themselves but are economically equivalent to cash flow movements. In 2016 the IASB published an amendment to IAS 7 Statement of Cash Flows, designed to help users reconcile changes in liabilities arising from financing activities.
In addition to the issues outlined above, the extent of reinvestment opportunities and cash flow generation will be important considerations in determining the most appropriate dividend policy for a company. When a business faces financial stress it can be important, sometimes essential, to reduce the dividend strain on cash flow.
© IASB - International Accounting Standards Board
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