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Red flags in the FTSE 100

Liberum analysts have flagged accounting, governance and other concerns at the UK's largest companies
October 23, 2015

Analysts at Liberum recently ranked the UK's 100 largest companies based on a number of 'red flags', ranging from the aggressiveness of their accounting to the number of independent directors on their boards. Outsourcing giant Babcock (BAB) and security services provider G4S (GFS) were the worst offenders, raising five of the 12 flags, while BAE Systems (BA.), Coca-Cola HBC (CCH), Imperial Tobacco (IMT), Johnson Matthey (JMAT) and Pearson (PSON) sounded alarms on four measures each.

Liberum's red flags fall into five categories: risks of material misstatement outlined by independent auditors; profit smoothing, comprising exceptional items, provisions for bad debt and revenue-recognition policies; working capital, encompassing inventory management and the time taken to pay suppliers; cash uses, specifically which companies have insufficient cash generation to fund dividends or have deferred maintenance spending to flatter their free cash flow; and miscellaneous and governance, including board independence, goodwill impairment and the potential impact on companies' debt piles of proposed accounting rules requiring operating leases to be capitalised.

G4S emerged as the business with "most risk of material misstatement" in terms of its financials, according to the report, based on its complex revenue-recognition policies and the significant role of managerial judgment in estimating its goodwill. Liberum also highlighted the group's regular use of exceptional items, under-investment in assets, growing number of "doubtful debtors" and inability to cover dividends with cash - high labour costs, business investments and lower margins have hit cash generation. But it was far from the only offender: the broker called out Arm (ARM) for consistently classifying share-based payments to employees - a key portion of annual compensation - as one-off expenses, Pearson for paying dividends that are out of kilter with its cash generation, and Capita (CPI) as only a third of its board members are independent.

However, Liberum's process is far from infallible: several companies were flagged due to their stated strategies. Babcock and Aberdeen's (ADN) maintenance spending has been low as they've deployed funds to make acquisitions, while Johnson Matthey has been holding on to inventory for longer due to rising orders in its petrochemical catalyst business.