April 2018 - By Andrew Mc Robert
Warning signals: making the numbers talk
“I honestly think that people are too trusting, and most are flat out trying to survive”, wrote a recent purchaser of our book. She went on: “I have decided to question more, to make that phone call to investigate for myself instead of listening to hearsay.”
The letter was prompted, needless to say, by the collapse of One.Tel and HIH. So it’s probably useful to ask whether the collapses could have been anticipated from the financial statements.
Of course, many investors will say: “I don’t understand financial statements, and I’m, not an accountant.” There are plenty of basic courses in understanding financial statements-the Certificate course run by the Securities Institute of Australia is probably the most accessible. And in any case, common sense plays an enormous part in understanding the fortunes of a company (maybe that’s why the professional analysts get it wrong so often!).
So this article take a look at the most recently published financial statements for HIH and One.Tel, to see if there were any warning signals of their impending financial doom. In doing so, it avoids the complex financial analysis (supposedly) carried out by professional analysts, and concentrates on a small number of relatively simple analytical exercises.
In the first place, we will ignore the purple prose at the front of the annual report. We will also the financial summary statistics at the front of the report. Those were prepared by management, and, in all fairness, are designed to highlight the excellent features of the company. The serious investor wants all the news, not just the good news!
We will then only pay passing attention to the audit report. If it is qualified, it goes without saying that the company is outside the scope of a Serious Investor. If it is unqualified, it means ABSOLUTELY NOTHING. I’m a chartered accountant, and even though I appreciate the good work done by my professional colleagues, we have seen too often that companies can fail, and fail extremely rapidly, after receiving a clean audit report.
Over time, the serious investor is going to want to pay attention to accounting policies. It never fails to amaze me how many companies entering into a period of financial distress attempt to disguise it by changing the accounting policies. So a nice simple warning signal is to read note 1 very carefully. If a company tells you that it has made a change of accounting policy, and if their explanation doesn’t meet the common sense test, and if the change has had a major impact on the profit or the balance sheet, be very afraid! If the company has made the change and hasn’t told you, be even more afraid!
Guess what: HIH made a number of changes in policy or presentation between December 1998 and June 2000 (the company changed its year-end, and therefore presented 18 month accounts). Unfortunately, because the 2000 accounts were abbreviated, the changes in accounting policy were not adequately explained. So the analysis set out here is based on a fudge factor, but I don’t think it changes the results. It does, however, ring a warning bell.
Now let’s think about what you are looking for in a set of company in which you invest. Good companies generate sustainable operating cash flows, that is they don’t need one-off profits, changes in accounting policies, or accrual accounting tricks that generate profits without boosting cash flow. So we want to see whether the company is generating sustainable profits and cash flows. And this can’t be done with just one year’s figures.
Secondly, we want to see whether the company is likely to be around long enough to generate those sustainable earnings and cash flows. There are two considerations: has the company got enough liquidity to meet its current payment obligations, and has the company got enough shareholders’ funds to act as a buffer against losses?
Then we need to have a quick look at gearing, which is the relationship between shareholders’ funds and external liabilities. There are no hard and fast rules about gearing: more volatile and newer companies tend to have higher gearing, older and more stable companies lower. Financial institutions tend to have higher gearing and so on.
We are concerned about three things. Firstly, has the gearing been stated properly? It’s important to read the notes very carefully, and particularly the note on contingent liabilities. It’s amazing the number of companies that manage (or try) to disguise actual liabilities as contingent liabilities. Read the contingent liability note with a large dose of common sense and scepticism. To paraphrase an old expression: if it looks and smells like a rotten egg, it probably is a rotten egg.
Secondly, has there been any significant deterioration either in the total amount of creditors or the nature of lenders? Have a much larger proportion of loans become current (i.e. due in the next twelve months) or secured?
Thirdly, what proportion of shareholders’ funds is made up of intangible assets? I know the accounting writers can make a very sound case for bringing brand names, goodwill, trade marks and so forth into the balance sheet. But, as creditors grow, companies need more real money injected as capital, and revaluations of intangible assets aren’t real money.
Now let’s turn to the real stuff: cash flow. You can’t pay lenders with profits. You can’t pay the wages with profits. And you can’t expand the business with profits. You need cash flow. Growing companies (such as One Tel), use enormous amounts of cash: as their sales grown, so do their debtors and inventories, and this requires continuous injections of new cash. If they don’t arrange those injections of new cash, or if they put it in and then take it back out again (remember the bonuses to the directors), the company runs out of money.
I had a look at the concise financial statements for One.Tel for the past three years, and for HIH for the past five years. Briefly, what they show is described below.
A few things bothered me about One.Tel's financials, even before looking at warning signals. Why, when the company was expanding at an enormous rate, did they indulge in a $106 million share buy-back? That suggests complacency, which is always dangerous in a young company. It also bothers me that, of total assets of about $526 million (at 30th June 2000), $203 million, or nearly 40% was made up of intangibles (deferred expenditure, prepaid advertising, future tax benefits and other intangibles. As history shows, when One.Tel hit the wall, the value of those intangibles was exactly zero!
By the same token, the share subscription of $430 million doesn’t look so impressive (and neither do One.Tel’s gearing ratios) if the prepaid advertising of over $150 million was in fact contributed instead of actual cash for shares issued.
But the most telling issue emerging from the analysis is this: One.Tel’s net operating cash flow for 1999 and 2000 was negative. In 1999 it was $8 million negative. In 2000, it was nearly $114 million negative. This is the clearest warning signal that the company was burning cash at an unsustainable rate, and that all the Managing Directors’ assurances about $75 million cash in the bank needed to be taken with a large grain of salt. A second warning signal comes from some elementary financial analysis. One.Tel was a phone service provider. We all know what happens if you don’t pay your phone bill: they cut you off pretty promptly. So why was One.Tel showing 85 days receivables? In case after case, company directors make statements about the effectiveness of their collection systems, which a simple calculation like this suggests to be largely erroneous.
So, even a fairly unsophisticated look at One.Tel’s financials would have promoted a number of serious doubts about the company’s sustainability. In our book, we talk about trajectories of failure. Reading the financials of One.Tel in particular, one is instantly reminded of what we refer to in the book as Type 2 trajectories, more often referred to as rockets. They rise incredibly rapidly, and fall equally rapidly.
HIH, of course, is a much larger than One.Tel, and, as an insurance company, its financial statements are much more complex. There has been much discussion recently of alleged dubious accounting for reinsurance. The average investor could have picked none of this up. Nevertheless, there were also a number of worrying signs about HIH’s financial position.
A number of commentators have made the point that insurance companies generate investment income to complement the low returns from underwriting. That’s all very well, but HIH made underwriting losses in each of the past 5½ years. How was this sustainable, particularly as the investment climate turns down?
Why, when the company was unprofitable and cash flow negative in 1998 did it pay over $40 million in dividends?
And why did HIH dramatically restate profits for 1995, 1996 and 1997 in the 2000 accounts without an explanation? There are discrepancies totalling more than $90 million between the published results and the results in the prior year financial summary in the 2000 accounts.
Now let’s look at HIH’s cash flow (by my analysis, not the published cash flow statement). The following figures (in $mn) are revealing:
1997 1998 2000
Net operating cash flow 18.2 342.1 140.4
Interest expense 36.0 22.4 7.0
Cash debt service cover 0.5 15.3 20.1
In other words, in the 18 months before its last published accounts, HIH only generated half as much cash as it needed just to pay its interest. Can you imagine how your bank would react if you admitted that!
In the same 18-month period, HIH needed nearly $224 million to cover its funding needs (purchasing FAI and so forth). The analysis of where this came from is also revealing:
1997 1998 2000
Funding need 223.7 393.7 157.9
Lenders 23.7 423.8 14.3
% 10.6% 107.6% 8.4%
Shareholders 23.4 280.5 49.4
% 10.5% 71.2% 31.3%
Changes in cash balances -177.1 +435.0 -75.1
% -79.2% 110.5% -47.6%
So, like squirrels, HIH set money aside in good times to fund times when there were greater funding needs. But even in good times, the kindly lenders provided the great majority of the funding: when a company is growing as fast as HIH proclaimed itself to be, the shareholders would normally expect to be called on to shoulder a serious proportion of the debt.
It is fair to say that HIH’s financials didn’t show the dramatic warning signs that One.Tels’s did. But, reading both companies’ financials, one is irresistibly reminded of the shooting stars that we talk about in Corporate Collapse. Maybe age brings on conservatism, but I really believe long-term investors need to be very wary of shooting stars!
Financial statements will not always provide the warning signals that investors need, but they certainly have a better track record than rumour or gut feel. Between a common sense look at a few financial ratios, and some basic cash flow analysis, a careful investor can often gain enough insight to tell him or her that there is a profound gap between directors’ rhetoric and the actual situation of a company. After that, it’s up to the investor whether to take the risk of staying with the investment, or to “vote with his feet”.
And there are a couple of simple things to remember, whatever the basis of your investigations:
1. Common sense always rules in reading financial statements. Remember the rotten egg!
2. As Trevor Sykes always says, if the financials are telling you one thing and the market is telling you something else, always believe the market!