What tricks can investors use to spot the signs of an impending stock market disaster like Carillion’s collapse, the fraud at Patisserie Valerie or Tesco’s 2014 accounting scandal? It is a question we’ve put to three experts in forensic accounting and the easy-to-follow techniques they’ve highlighted could save others from making costly investment mistakes.
But before revealing all, it is worth considering how best to use this advice. The idea of short selling can seem very attractive. But Matthew Earl, one of the expert contributors to the advice in this article, who runs a short-focused hedge fund, suggests would-be short sellers think twice. “No one in their right mind wants to be a short seller,” he says. “I believe you’re just born a short seller.”
Indeed, the asymmetric risk that favours owners of shares (in theory there is infinite upside to a share price but only 100 per cent downside) works in reverse for short sellers. So, for readers who do not fall into that rare category of “born short seller”, perhaps the best way to apply the advice in this article is illustrated by the “iceberg principle”, as expounded by another contributor, retired fund manager and financial author Tim Steer.
“I think warning signs in a financial statement or annual report are like icebergs in that they won’t tell you everything,” says Mr Steer. “With an iceberg, 90 per cent of the ice is below the water, but when you see what’s above the water line, you avoid it. It’s the same if you can see a problem in a company’s accounts. It could be something as mundane as a provincial auditor or that accrued income has gone up. It is advisable to steer clear of the company because there will often be plenty of other problems that are out of sight.”
For anyone unsure whether it’s worth the effort of extending their knowledge of company accounts beyond the shiny profit-and-loss statement and headline numbers into the murky world of the balance sheet, cash flows and the hidden gems found in the notes to the accounts, here are some salient thoughts from Steve Clapham, the third contributor to the advice in this article and a former Toscafund partner and owner of research and financial training firm Behind the Balance Sheet.
“The whole financial world is designed to embezzle you. Look at pensions; the second most important financial decision of most people’s lives. Even I as a professional investor don’t understand much of the jargon – what chance does the average person have?” He adds, “If you want to invest and be secure you’ve got to put in a certain amount of effort. When you go into the stock market you’re competing with professionals.”
The tips offered by our three experts for spotting deteriorating, aggressive and plain dodgy accounts have been split into four broad areas: ‘Balance sheet confidential’ looks at the clues in the balance sheet that suggest earnings may be being manipulated and how to use key ratios needed to detect suspect behaviour; ‘Compare, contrast, common sense’ explores the importance of sense-checking business models and forecasts and methods for comparing companies with their peers; ‘Cash is king’ examines the importance of cash conversion in corroborating profit numbers and how to measure and analyse key cash conversion ratios; and finally ‘The nature of the beast’ looks at the corporate governance issues that can suggest bigger problems exist.
So, without further ado, let’s find out our three experts’ top tips on how to spot red flags.
Balance sheet confidential
Balance sheet ratios can be invaluable for investors trying to spot deteriorating, aggressive, or even fraudulent accounts. If there is questionable reporting on the profit-and-loss account, then it will often be the balance sheet that provides the clues that not everything is right. As Mr Steer says: “The balance sheet is the place to look for funny stuff because that is where all the bad things are put. The profit-and-loss account is where all the good stuff is because that’s what they want you to look at.”
So what should investors look out for? There are three key balance sheet ratios highlighted by our experts and Mr Steer also suggests a more granular examination of one of the key ratios can be hugely helpful, while the composition of debt and capitalisation of costs can also provide red flags.
Three balance sheet ratios tell investors: if a company is actually being paid for what it claims to have sold during a reporting period (the debtors/sales ratio or debtor days); the level of costs built up that will need to be accounted for against future sales, or in the worst case scenario written down (inventory/sales ratio or inventory days); and the amount of credit the company is getting from its own suppliers (creditor/sales ratio or creditor days). It is absolutely normal for companies to have debtors, inventory and creditors; it is when they start to move to extreme levels that investors need to watch out.
Debtors/sales and debtor days
The debtor/sales ratio is a key ratio for detecting trouble. All three of our experts highlighted it as among their top tools for identifying weak accounts.
The debtors on a company’s balance sheet represent the amount the company is owed. Normally this chiefly reflects work that the company has done but not been paid for (and may or may not have invoiced for) which has been recorded as income in the profit-and-loss account. It can also include prepayments by a company for goods or services it has not yet received, such as paying rent in advance. In either case, the company believes it is owed something.
If a company seems to think it is owed an awful lot compared with its reported sales, and the amount it is owed compared with sales has been rising, then it can be a sign of trouble. Rising debtors to sales will have a negative impact on operating cash conversion because sales are not being turned into cash (see ‘Cash is king’). What’s more, if it is taking a long time for a company to be paid, its customers may not actually be able to pay, it may be reporting revenues that its customers do not believe it is due or reported sales may even be fictitious (see ‘Digging deeper into debtors’).
Where to look for debtors?
A company’s debtors are chiefly found in the ‘Current assets’ section of the balance sheet and will usually appear next to the title ‘trade and other receivables’. Financial companies do not lend themselves to this analysis as their loans are recorded as receivables (ie money owed to them) and their balance sheets are different in nature to most companies. Investors also need to be careful when looking at companies with big consumer credit operations, such as retailer Next (NXT), to be sure what portion of receivables represent profitable lending as opposed to outstanding invoices. Sometimes companies have receivables listed among their ‘Non-current assets’, implying they do not expect to be paid for over a year. While the same rules apply (watch out for high or rising numbers relative to sales), non-current receivables should be treated with extra caution.
To calculate debtors/sales, simply divide total debtors by a company’s revenues. As a rule of thumb, when debtors represent more than 25 per cent of sales, or if debtors to sales has been rising persistently or sharply, it is something that is worth investigating. Some investors like to look at the debtors to sales ratio in terms of the number of days it takes for bills to be paid. If you want to do this, simply multiply debtors to sales by 365 (the number of days in a year).
Here’s what happened with Carillion in the years leading up to its collapse:
“A drift up in debtor or inventory days is often a presage to a problem,” says Mr Clapham. “The best tools are always simple. You should look at the trend versus history and the level versus peers. Any deterioration is the signal of a problem.”
Creditors/sales and creditor days
Creditors are the flipside to debtors. These are chiefly suppliers that a company owes money to, but they can also represent deferred income – goods or services the company’s clients have paid for in advance. Creditors are generally to be found in the ‘Current liabilities’ section of the balance sheet under the title of ‘trade and other payables’.
Creditors to sales is calculated in the same way as debtor to sales (dividing creditors by sales) and also is often expressed as a percentage or in terms of days by multiplying the ratio by 365.
There can be two worrying signs that emerge from creditor to sales. If the number is falling and low, it could be a sign that suppliers are so wary of a company that they will only do business with it if they are paid upfront. Meanwhile, a high and rising creditor/ sales ratio can be a sign that a big powerful company is pushing its suppliers too far.
“A large amount of industrials have stretched their creditor days to the limit. Some are around 100 days. Cash flow at these companies has done extraordinarily well from this, but there is not much more to come,” says Steve Clapham. “There is often a lot of window dressing around the time of the year end.”
Window dressing can make a company look more financially sound than it is by boosting reported cash flow by temporarily delaying payments. Stretching payment terms can also lead to a blow-up with suppliers. These were key issues behind the 2014 accounting scandal at Tesco (TSCO). This is what happened to the supermarket giant’s creditors to sales ratio in the run-up to its devastating profit warning, as it pushed out payment terms and booked supplier rebates as revenue.
Inventory to sales and inventory days
Inventory represents the amount spent on goods that are ready to be sold (recorded in ‘current assets’, as ‘stock’ or ‘inventory’) and goods that are currently being made (‘work in progress’). When the goods are sold, the value of the inventory moves from the balance sheet to be recorded as ‘cost of sales’ in the profit-and-loss account. The problem often comes when a company cannot sell its wares or can only do so at a loss. Then the temptation is to build up stock levels which more than likely will be a case of building up trouble for the future – usually in the shape of writedowns.
“When stock is rising as a proportion of sales, you might have stock obsolescence and provisions coming,” warns Mr Steer. “It is key to remember that the higher the closing stock valuation, the higher the profit a company will make.”
There are two standard ways to look at inventory, either as a percentage of sales or as a percentage of cost of sales. Inventory days are based on inventory divided by cost of sales multiplied by 365. Below is a chart showing what happened to stock levels at Tesco before its 2014 profit warning when it was found to be overstating stock values by not properly adjusting for rebates.
Take note of the notes
Sometimes the really good things only come to those who wait. This is often the case with company accounts. While the preliminary results published by companies over the regulatory news service (RNS) provide plenty of important information, there is a greater depth of information in the full annual report and accounts that companies publish a bit later and make available on their websites. The notes in these accounts provide valuable detail on accounting policies as well as added depth on many of the numbers found in the prelims.
Deeper into debtors
Not all debtors are equal. While it is easy to put a value on work that has been invoiced for (trade receivables), other types of receivables, such as work that a company judges to be complete but which the client is yet to be billed for (accrued income), are far more reliant on management judgement. Sadly, judgement can sometimes be found to be lacking.
“If you see accrued income going up and up on the balance sheet, mind your eye,” says Mr Steer. “If you ask the client if they think they owe that money, they’ll probably say they don’t. It’s just an estimate of what a company thinks it is owed, and you have to remember it is pure profit. And if accrued income is more than one month of sales, mind your eye.”
Mr Steer suggests one of the most valuable checks investors can perform is to watch out for a deterioration in the quality of a company’s current assets, especially receivables.
“On the scale of current asset quality, you have cash at the top followed by trade receivables. After that we are getting less good. You have amounts recoverable on contracts and then accrued income. It’s about how current assets turn into cash and the easiest thing to turn into cash is trade receivables, and it is also easy to audit. The lower quality current assets are very hard for auditors to corroborate. The auditor often just has to take management’s word for it.”
Here’s what happened to the breakdown of Carillion’s receivables in the run-up to its collapse:
Deeper into debt
It is widely acknowledged by investors that a high level of debt, especially when set against unstable or cyclical earnings, is a dangerous thing. However, clues to the financial strength of a company can be found in the type of debt a company has taken on as well as the overall amount. The use of invoice discounting (borrowing against outstanding invoices for a fee) is often regarded as a classic sign of a company struggling to get financing from less expensive sources. But there are new schemes emerging all the time. Mr Earl highlights the recent rise in Schuldschein lending, which allows companies access to finance with little scrutiny of their creditworthiness.
“Is the debt bank debt?” say Mr Earl. “Schuldschein loans have been a growing source of credit. They have no covenants, limited reporting and no credit rating requirement. These are loans to the company marketed by banks to family offices… Never underestimate the credulity of family offices, or others, for the gain of a few extra basis points.”
The emergence of Schuldschein lending was a noteworthy feature of Carillion’s borrowings prior to its collapse (see chart below). Companies provide details of the composition of their debt in their annual reports, often in the notes.
Use the balance sheet for what it’s meant for!
The balance sheet shows what investments have been made into a company over the years. For example, when a new van is bought, rather than record the entire cost against turnover for that year, the van’s value is put on the balance sheet and then every year over its useful economic life the cost is accounted for as a depreciation charge in the profit-and-loss statement. It makes sense to account for an investment in this way because management and shareholders are able to judge the cost of an asset over its life against the turnover it helps the company generate. But what can justifiably be regarded as an investment that should be on the balance sheet rather than an operating cost that should be expensed directly through the profit-and-loss account?
As a general rule, Mr Steer advises: “If more and more costs are being capitalised, you need to watch out. If a company is capitalising things like salaries, or software implementation, or development expenses, or the cost of buildings, you need to watch out, because these costs would usually go through the profit-and-loss account.”
Compare, contrast, common sense
A common strand in the approach used by our three experts is the desire to sense check what they’re told. As Mr Earl puts it: “As an analyst, you need to be very independent of thought, inquisitive and think outside the box. You don’t have to be overly pessimistic. We trust what companies say, but we will look to verify it.”
This is a sentiment echoed by Mr Steer, “You need an enquiring mind, which means getting third-party corroboration of what people say about a company. If a motor retailer says sales are up 20 per cent, it’s probably worth checking with another motor retailer that their sales are up too.”
Mr Earl also emphasises the importance of understanding a company in the context of its own history and forecasts in the context of an end market. “The market prices things on a forward earnings basis. The interesting thing is how optimistic consensus forecasts can be on an analysis of the actual market a company is present in.” He uses the example of a short position he took in an electronic invoicing firm named Tungsten that rolled invoice discounting (lending on outstanding invoices) into the service it provided.
“Invoice discounting is as old as time,” says Mr Earl. “It’s not anything new, but the wording around [Tungsten’s invoice discounting service] whipped everyone up into a frenzy. But when I looked at consensus forecasts in terms of the market share they would have to take it seemed absurd, especially when they’re competing with very established incumbents. Did it make any sense at all they’d be likely to achieve that in the context of that market? In the event, sell-side analysts’ forecasts proved wildly optimistic.”
Mr Clapham perhaps has the most easily applicable suggestion for a practical test on this key issue.
“My number one check is to compare a company’s margins with its peer group,” says Mr Clapham. “The question is what are the characteristics of the business that could explain the margin being very different. If one company is making a 15 per cent margin and everyone else in the peer group is making 10 per cent, you ask if it has got a particular advantage.”
Finding the outlier has the potential to alert investors to companies with superior business models but can equally provide a warning that the accounts are too good to be true. Mr Clapham highlights the case of the fraud at cake café chain Patisserie Valerie.
“Patisserie Valerie’s margins were higher than Starbucks,” he says. “But coffee is higher-margin than cake, and much of Starbucks’ business is takeaway. Are cakes a higher-margin business than coffee? Coffee is just beans and water. Cakes take hours to make and go off if they’re not sold. People are sitting down to eat them and someone has to serve them, someone has to wash the plate and someone has to take the bill over. All that means more staff and space, and wages and rent are some of the biggest costs for restaurants. There are quite a lot of things going on around that cake. Investment is about common sense, and that’s common sense.”
The table below shows a comparison of Patisserie’s Ebit margin over the past five financial years against those of some comparable London-listed peers (food-led pubs, concession operators and eateries chains).
|Patisserie Valerie’s Ebit margin vs peers|
|Last financial year (FY)||FY 1||FY 2||FY 3||FY 4|
|The Restaurant Group||8.10%||8.60%||11.10%||13.00%||12.60%|
|J D Wetherspoon||7.80%||7.70%||6.90%||7.40%||8.30%|
|Source: S&P CapitalIQ|
Cash is king
Another unifying theme from our experts is the overarching importance of healthy cash conversion. “The thing you need to remember with every number in the accounts apart from cash is that they are a matter of opinion,” says Mr Steer. “There is a lot of scope for manipulation.”
“Has profit been at a certain level but cash flow not?” says Mr Earl. “It’s important to be looking at these things on a cumulative basis. If you want to understand where a company is going to, you have to understand where it has come from. If a company has been a constant burner of cash, whereas it claims to have rising profits, that’s something to investigate.”
Here’s how Carillon’s free cash flow (FCF) looked compared with profits after tax (PAT) in the run-up to its collapse shown on a cumulative five-year basis.
How can you measure cash conversions?
Cash conversion sounds like it should represent something very definite given how tangible cash itself is. However, there are many different ways to assess cash conversion and it is always worth checking what companies mean when they use the term. Indeed, companies can use all manner of adjustments that often make things appear better than an alternative calculation method would suggest.
There are two key standard measures of cash conversion that are very useful for investors. These are operating cash conversion and free cash conversion. It is important to remember there are often good reasons why cash conversion may look weak; for example, growth can consume a lot of cash in increased requirements for working capital and capital expenditure. However, if cash conversion is weak, it is worth finding out whether the reasons for this stand up to scrutiny.
Operating cash conversion
Operating cash conversion compares cash from operation before tax (found towards the end of the first of the three sections of the cash flow statement) with a company’s operating profit (found in the profit and loss account).
Sometimes, though infrequently, companies take interest charges inside operating cash flow. When this is the case, the interest cost should be reversed out as operating profits are stated before interest expenses and the point of calculating cash conversion is to compare like with like.
While cash flows can be lumpy from year to year depending on the nature of the business, over the long-term, as a rule of thumb, investors should want to see operating cash conversion of over 100 per cent.
The reason why operating cash should be higher than operating profit is that operating profit includes non-cash amortisation and depreciation charges (these profit-and-loss charges reflect reductions to the value of assets on the balance sheet that have been created by historic investments in the business and acquisitions).
Free cash conversion
Free cash flow (FCF) represents the amount of money that is available to return to shareholders or spend on other things such as acquisitions or debt repayment. FCF is what is left over after the company has paid all its taxes, interest to banks and other costs. This can be calculated by taking operating cash flow after tax and subtracting net interest expenses (including dividends to preference shareholders) and capital expenditure (on both plant, property and equipment, and intangibles).
Some calculations of FCF try to only factor in capital expenditure on maintenance, but estimating this can be very complicated and inexact, so in many cases arguably is not worth the considerable effort.
FCF is compared with after-tax profits to calculate free cash conversion. Big capex projects can make free cash flow particularly lumpy and it often lags pre-tax profits. As a rule of thumb, looking for free cash flow conversion of 80 per cent or more over time suggests a company is doing a decent job of turning profit into cash.
The nature of the beast
The way a company is structured, its cosiness with its auditor and the checks on executive directors can provide important clues to the integrity of its reporting. Our experts cite several red flags that investors can look out for which are listed below.
1) Who is the auditor: Listed companies using provincial auditors can be a warning sign as relationships can be very cosy. This red flag extends to regional offices of big-name auditors.
Other signs to look for that could suggest an overly cosy relationship with auditors include: companies employing auditors where key executives (particularly the chief executive and finance director) previously worked; auditors earning large consultancy fees in addition to their audit fee (although regulation has sought to curb this); and companies that have maintained their auditors for a long period of time (think seven-year itch). To stick with the Carillion example, it was audited since inception in 1999 by the same Birmingham branch of KPMG.
However, in this age of ‘blame the auditor’, Mr Earl has some sobering words for anyone who thinks the auditor’s oversight will ever be enough to protect them from a grievous event. He says: “Audit firms are not there to identify fraud. They are there to offer professional scepticism. If you have collusion to defraud investors it is very hard to identify that.”
2) Cosy directors: Best practice in corporate governance recognises that it is desirable for a company’s executive directors to have their ideas challenged. However sometimes this is something that is not desired by executives themselves. Mr Earl says, “When successful businesses have a founder as a chief executive for a long time, as the years go by they can surround themselves with people who will not question their judgement.”
A lack of quality independent boardroom oversight can allow bad behaviour to develop unchallenged over time and can serve as another red flag.
3) Related parties: Investors should feel uncomfortable when a director or relation to a director is paid for providing services to a company, leasing it assets (such as property) or selling it a business or asset. The question with these kinds of transactions is whether the director is incentivised to serve the best interest of the company’s shareholders or themselves. Mr Earl also highlights as a related issue the posting of shares as collateral for loans as was infamously the case with Rob Terry at disaster-struck legal services firm Quindell.
Indeed, all the contributors to this article pointed out the importance of understanding what the incentives are for key actors. As Berkshire Hathaway’s Charlie Munger has famously quipped: “Show me the incentive, and I’ll show you the outcome.”
4) Structural strangeness: Another potential red flag can be raised by companies with sprawling structures comprised of multiple joint ventures where it has non-controlling interests and associates. This is especially the case when it is not clear how the individual entities’ accounts are consolidated or when they operate in geographies where audit work is likely to be of a lower quality.
Investors should be especially wary of relationships where a company provides equity funding and loans to a company it sells a lot to due to the potentially circular nature of cash flows.
That’s it for our expert tips. While there is no single sure-fire way to smoke out trouble in company accounts, there are plenty of checks that can alert investors to be on their guard. Hopefully, the techniques outlined in this article will provide readers with some valuable tools.