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How a company's balance sheet can mislead investors

Cash and debt balances can mislead investors and trick them into thinking that companies are better and their shares are cheaper than they really are
August 14, 2019

Two of the most important figures in a company’s financial statements are its cash and debt balances. Both have a big influence on how we view its financial performance and the value of its shares. Yet sometimes, the figures on a balance sheet can mislead us. Investors can also treat cash and debt balances in the wrong way and mislead themselves into thinking a company is better or cheaper than it really is. I take a closer look at how you might avoid these pitfalls.

What is cash and debt?

This is not just a pile of bank notes and coins, but will include various bank accounts that are used for different purposes, such as paying wages, paying suppliers and petty cash used for small day-to-day expenses. 

Usually a company shows its cash balances and cash equivalents. Cash equivalents will include things that can be turned into cash fairly quickly, such as money market accounts and short-term government bonds. It will not include items such as shares, which will be classified as investments. Some investors do think that share investments are as good as cash, particularly if they are highly liquid and the cash can be realised easily and quickly.

Debts are usually referred to as borrowings. They can take many different forms, including bank overdrafts, bank loans, finance leases, debentures (loans secured against assets) and bonds. Then there are other liabilities that have very similar characteristics to debt, such as preference shares, pension fund deficits and operating leases associated with rented assets.

 

Cash and debts in a company’s financial statements

You will see it in two places. The company’s cash balance is shown on the face of its balance sheet under current assets. Its cash flow statement tells you how that cash balance has changed over a period of time.

Debts are found on the balance sheet under current liabilities (to be paid in one year or less) and long-term liabilities (greater than one year). Again the cash flow statement can tell you how a company’s debt balances change over a period of time. 

As many investors have found out to their cost, debts can also be hidden off balance sheet in joint venture companies or when a contingent liability – one that arises due to the occurrence of an event – materialises. For the purposes of this discussion, I am just going to look at debts that are disclosed on the balance sheet.

Let’s have a look at a real company example to see how this works out in practice and see how the debt and cash figures on the balance sheet might not be giving investors the true picture of the company’s financial position throughout the year.

I am going to look at the balance sheet of Lookers (LOOK), one of the leading car dealerships in the UK.

Lookers' balance sheet

Source: Annual report

Let’s deal with the cash balance first. We can see that it has decreased by £0.9m to £44.4m. More details of this can be found in note 15 to the accounts. You should always look at the notes as often there is a great deal of information in them that can significantly enhance your understanding of a company.

This note is slightly confusing because the figure for cash and cash equivalents includes the netting off of bank overdrafts. When these have been taken into account, the balance has increased by £4.4m. Let’s move on to the cash flow statement, which always tells you a lot about what has been going on.

Lookers' cash flow

Source: Annual report

 

The £4.4m movement in the cash balance is calculated by summing the totals of the following:

  • Net cash inflow from operating activities of £54.9m.
  • Net cash outflow from investing activities of £12.2m.
  • Net cash outflow from financing activities of £38.3m. 

You should spend time examining the changes in each of these three categories, but we are just looking to check the actual cash balance at the moment. It’s reasonably easy to see how the balance changed during the year. Now let’s turn our attention to borrowings or debts.

The first thing to notice is that they are all bank loans, which are effectively repayable on demand, which might be an issue if we go through another credit crunch like 2008. Borrowings have come down by £11.8m to £131.3m. We can also see that there is a shift in the maturity of the loans from one-to-two years to two-to-five years. Very little debt has to be repaid in the next year.

The company’s net debt – its total loans less cash balances – has come down from £97.8m to £86.9m. This is usually seen as a good thing, but such a view needs to be treated with caution.

 

Lookers plc

2018 (£m)

2017 (£m)

Total loans

131.3

143.1

Less cash

-44.4

-45.3

Net debt

86.9

97.8

Source: Annual report

 

The problem for investors is that cash and debt balances shown on the balance sheet are a snapshot on one day. They may not be representative of average debt and cash balances that exist throughout the year. In many cases, the differences between year-end and average levels can be very big. As we shall see later, this has big implications for interpreting a company’s financial performance and the value of its shares.

Companies have a tendency to present their financial position in the best possible light and this tends to be when it is as its most favourable. It is not surprising that tour operators have annual balance sheets at the end of September when its customers have paid for their holidays, but it might not have paid for the hotels they stayed in and the airlines that took them to their destinations. Many general retailers have December balance sheets just after the peak Christmas trading period when cash has been paid by customers but suppliers have not yet been paid.

On the issue of debts, one of the best ways of seeing if average debts are different from year-end debts is to calculate the effective interest rate on its debts. I do this by taking the cash interest paid from the cash flow statement and dividing it by the average of the opening and closing total debt position.

Lookers paid £18.6m of interest on average total debts of £137.2m. This gives an effective interest rate of 13.6 per cent,  which looks incredibly high in a world of low interest rates. When you see a high effective rate of interest it is often telling you that average debts are much higher than year-end debts. As is often the case, the answer to this in the case of Lookers can be found by looking at the notes to the accounts.

As we can see, Lookers paid £5.6m on its bank borrowings, which gives an effective interest rate of 4.1 per cent, which looks more sensible. We can also see that there is an interest rate charged on consignment vehicle liabilities and stocking loans.

Consignment stock mainly relates to part-exchange vehicles and ex-lease cars which the dealer is holding for resale but does not hold the legal ownership of them. This stock is financed with borrowings where an amount equal to the stock is accounted as a trade creditor. At the end of 2018 Lookers had £480m of consignment stock compared with £442m a year earlier. The average effective interest rate on the stock is 2.8 per cent.

My issue with this is that this consignment stock appears to be debt in all but name. It is similar to housebuilders buying land on credit. The land creditors are not counted as debt, but some building companies do – to their credit – calculate their debt ratios by including them. 

Tui (TUI), the tour operator, had net cash of €105.1m at the end of September 2018, which was made up of €2,548m of cash balances and €2,442m of debts. Yet it had interest expenses for the year to 30 September 2018 of €165m. At the half-year in March it had net debt of €639.7m. It is clear from the interest payments that this company has a significant net debt position for most of its trading year, yet how many investors are appraising it and valuing it on the basis of its year-end net cash position? My guess is quite a few are.

Another thing to bear in mind with company cash balances and therefore its net debt position is that they can be significantly distorted by payments made by customers in advance of delivery of a product or service. This increases a company’s cash balances, but because the money has not been earned yet there is a corresponding and matching deferred income creditor on the balance sheet as well. 

This is relevant for subscription businesses such as those found in publishing or software. Defence companies such as BAE Systems (BA.) often take big payments in advance. 

 

Implications for company analysis – should we be netting off cash balances and using average debts?

In short, I think the answers to these two key questions are no and yes respectively, but some flexibility is required.

It has been common practice for analysts to net off cash balances from debts – and use net debt – when calculating performance ratios such as return on capital employed (ROCE) and enterprise value (EV). In my view, this is only justified if the cash balance is truly available to pay off debts. In many cases it is not.

Quite often the year-end cash balance is flattered by the timing of payments at the period end. If a company delays paying its suppliers it has more cash – but higher trade creditors – than it would have, but that cash balance goes down when the bill is eventually paid. 

Even companies that have run substantial cash balances – and no debts – for years, such as Howden Joinery (HWDN) are arguably using them as a working capital facility to fund its business throughout the year. At the end of June 2019 it had £217.1m of cash on its balance sheet, but short-term trade creditors and tax liabilities of £323.9m. 

How much of that £217.1m is really free to be netted off the calculation of capital employed and EV? My view is very little as the trade creditors have already reduced it. Cash is essentially an asset that a company has to earn a return on just like a factory or stock.

Let’s look at the difference in treatment of netting off cash, and including it can change the calculation of ROCE and EV for companies.

 

Company (£m)

Lookers

Howden

BAE Systems

Fevertree

Total assets

1895.2

865

24746

225.4

less current liabilities

-1239.2

-253.1

-9307

-42

Add: short-term debt

2.6

0

785

6.1

Capital employed

658.6

611.9

16224

189.5

Less cash:

44.4

231.3

3232

89.7

Capital employed 2

614.2

380.6

12992

99.8

Operating profit

73.4

240.1

1928

75.7

ROCE 1

11.1%

39.2%

11.9%

39.9%

ROCE2

12.0%

63.1%

14.8%

75.9%

     

Market capitalisation

171.3

3180

17792

2566

Debt

131.3

0

4299

6.1

Pension deficit

68.9

36

4573

0

Enterprise value1

371.5

3216

26664

2572.1

less cash

44.4

231.3

3232

89.7

Enterprise value 2

327.1

2984.7

23432

2482.4

EV/Operating profit 1

5.1

13.4

13.8

34.0

EV/Operating profit 2

4.5

12.4

12.2

32.8

Source: SharePad

 

We can see that for companies with big cash balances, such as Howden Joinery, BAE Systems and Fevertree, netting off cash significantly boosts ROCE. It also lowers EVs and the EV/operating profit multiple, making the valuation of the business look cheaper.

For Lookers, the debt-like consignment stock is included in total assets and is counted in capital employed. I have not added it to EV, but do question whether I should have as it is a grey area. It might not be a debt from an accounting point of view, but it looks and acts like debt in many ways.

Now look at what can happen when you come across a company that tells you that its average debts are higher than its year-end debts. This was the case with Galliford Try (GFRD) last year where average debts were £325.2m higher. 

This higher average debt increases capital employed and EV. I have created a third calculation for both which adds this figure but does not net off cash. 

 

Company (£m)

Galliford Try

Total assets

2900.3

less current liabilities

-1802

Add: short-term debt

617.1

Capital employed

1715.4

Less cash:

912.4

Capital employed 2

803

Adj for higher average debt

325.2

Capital employed 3

2040.6

Operating profit

196.2

ROCE 1

11.4%

ROCE 2

24.4%

ROCE 3

9.6%

  

Market capitalisation

627.3

Debt

814.2

Pension deficit

0

Enterprise value 1

1441.5

less cash

912.4

Enterprise value 2

529.1

Adj for higher average debt

325.2

Enterprise value 3

1766.7

EV/Operating profit 1

7.3

EV/Operating profit 2

2.7

EV/Operating profit 3

9.0

Source: SharePad

 

So what ROCE did Galliford Try make in 2018? Was it a very good 24.4 per cent when cash balances are netted off and higher average debts are ignored or a modest 9.6 per cent when higher debts are included and cash is not netted off?

Many will argue strongly that netting off cash is perfectly fine. I think you should always be prudent when weighing up a company as quite often that cash is not available to net off debts. As you can see, the approach that you can take can make a big difference in how you view a company’s financial performance and its valuation.