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OPINION

The death trap

The death trap
May 23, 2018
The death trap

Apparently, the FRC – “our mission is to promote transparency and integrity in business” – struggles to distinguish between the two. Or, at least, the council seems to have a touching faith in the scope of a company’s reported reserves to measure its ability to pay dividends.

Both these observations – those of the politicians and of the bean counters – come from preliminary investigations into Carillion’s spectacular implosion in January. In its report, a joint committee of the Commons was relentlessly critical of the “rotten corporate culture” engendered by the “self-pitying” bosses of the failed FTSE 100 construction services group who were the villains of “a story of recklessness, hubris and greed”.

Some months before and less spotted, the Financial Reporting Lab – a sort of think-tank within the FRC – was unlucky enough to have praised Carillion’s accounts for providing “insights into factors relevant to the setting of dividends”; indeed, the very dividend payments that hastened Carillion’s demise. In particular, the reporting lab was impressed that Carillion’s bosses drew attention to “the likely available distributable reserves in the parent company” as a key factor in determining dividend payments.

It is a mystery why that should impress anyone since it’s a legal requirement – a company can only pay dividends to the extent it has such reserves. Yet that also prompts a broader – and more important – thought: which is the best metric to assess a company’s dividend-paying ability?

Retained earnings are important since they are the only part of a company’s capital that are distributable without special permission of the High Court. To the extent that they are profits that have built up over a long period, they might also be thought of as profits that have ‘matured’ into cash, with the accounting niceties that separate profits from cash having been washed out.

Dream on. If anything, the reverse is true – the passage of time means that retained earnings become just a book-keeping item, helping to balance a company’s liabilities with its assets; any relation to cash may have vanished.

That’s how it would appear to have been at Carillion. In the 2015 accounts that so impressed the FRC’s reporting lab, Carillion’s parent company ended the year with £373m of distributable reserves; plenty to pay dividends costing just under £77m. However, from the perspective of cash flow, the scene was completely different. In that annual report, Carillion’s directors had the gall to say that “the group is well positioned to continue to fund its dividends, which continue to be well covered by cash flow generated by the business”. Rubbish. That year, Carillion generated free cash – the cash left over for shareholders after all other dues have been met – of just £43m, little more than half the cost of the dividend.

That was part of a trend that had become entrenched. In the final five years of its dividend-paying existence Carillion cumulatively paid £376m-worth of dividends while generating free cash of less than £24m. In only one of those five years – 2014 – did free cash generated exceed the cost of dividends. That was in stark contrast to what had happened in the five previous years (2007-11) when Carillion paid £249m-worth of dividends against aggregate free cash of £388m.

Not that Carillion was necessarily alone – too many companies seem to overdistribute. Compare dividends paid with free cash generated by FTSE 350 companies (excluding investment trusts) for their financial years ending during 2017 and the average level of dividend cover is just 1.1 times (click on the link below for the full data set). Worse, 88 companies paid dividends that were not covered by free cash and 36 of those did not actually generate any free cash. Meanwhile, these companies had oodles of distributable reserves – on average, 16 times dividends paid.

True, it is risky to put much emphasis on one year in isolation because of the nature of cash flow. It’s an erratic figure, bouncing around as a company’s capital spending peaks and dips or as the need for working capital swings with the timing of payments in and out. So any judgment of a company’s dividend-paying ability depends on considering several years of data, all the while trying to figure out why cash flow is good or poor – is it due to one-off factors or just dull trading? Yet continual one-off factors often point to a deeper malaise. Is it linked to capital spending well in excess of rates of depreciation? If so, is such spending likely to be justified based on existing rates of return on capital, where – in simple terms – the higher the return on capital, the better? Is the company’s appetite for working capital voracious and is it continually rising faster than revenues? If so, that’s worrying, especially if it is linked to accounting profits that consistently run ahead of cash flow generation.

On most of these counts – though not all – Carillion was seen to be failing long before its demise. Sure, its collapse was unexpected, but the steady decline in its share price from mid 2014 onwards pointed to directors who had been sussed out by the market. For equity investors, Carillion is now history. The important question is, who will be next? Whoever it is, the likely clue will lie in the gap between profit and cash flow.