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Four Warning signs to avoid the next Steinhoff
Looking at Steinhoff and other companies that have been embroiled in accounting scandals in the past I’ve identified these four warning signs. Not all of these signs will be present for a company that is committing accounting fraud – but they are good indicators of trouble brewing.
Warning sign #1 – Low correlation between earnings and cashflows
We all love companies that report high profits, and consistent profit growth. But just as important as profits is cashflow.
So you should be looking at the net profit a company produces and compare that to its cashflows.
If a company consistently produces profits that are much higher than cash inflows there is something wrong.
Profits simply have to be backed up by cash coming into the business.
If it isn’t the chances are good that the company is doing one of the following:
1. Selling lots of product or services on credit – and not being able to recover the debts. This is a common problem with construction companies doing projects for government and then not getting paid. The project is invoiced and the ‘income’ is recognised on the income statement even though no money is recovered from the ‘deal’. This isn’t outright fraud – but it is a warning sign of impending trouble.
2. The company could also be ‘revaluing’ properties or other assets – recognising a profit on the revaluation. But this also isn’t money in the bank. And what often follows from this is refinancing of the asset with debt to increase cashflows. Watch out for companies that routinely include ‘once off’ profits in their financials. Once these kind of ‘once off’ profits become a material part of company profits you should be cautious.
Warning sign #2 – Low return on capital invested
One of the important metrics when I value companies is Return on Invested Capital (ROIC). This ratio tells us how good a company is at turning capital into profits.
And simply put – when the figure is very low you should think twice.
Steinhoff for instance had a return on invested capital of around 4.44% in September 2016. That should leave you asking – how can the company consistently grow profits year after year when they only get a 4.44% return off the money they invest?
Sure there are very large companies that can borrow on international markets at lower interest rates than this. But imagine a South African company, borrowing at 10% interest. Then investing that cash and getting a 4% return. That just doesn’t make sense.
You can calculate ROIC by taking Net Operating profit after tax divided by Invested Capital (Invested capital being all long term debt plus all equity of a company minus cash on hand).
Warning sign #3 – Complex shareholder structures or elaborate holdings companies
When a company has a too complex shareholder structure, or very elaborate holding companies you should watch out. The more complex these become – the harder it is for auditors to find accounting fraud.
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Warning sign #4 – Voting rights of shares not aligned with all shareholders
With this I am specifically thinking of companies like Naspers, Shoprite and Facebook. All these companies have other classes of shares that confer extra voting rights to certain shareholders. In Shoprite for instance, Christo Wiese controls 14% of the ordinary shares in the company but has voting rights for 42.3% of the company. That’s because he has a special class of share that accords him extra voting rights.
Naspers and Facebook are the same. In fact, Facebook voting rights are such that Mark Zuckerberg can stay ‘CEO for life’ or to appoint all new CEOs.
This doesn’t mean a company is committing fraud. But it does mean that there aren’t many ways for ordinary shareholders to hold management to account. As management would have all the voting rights and could effectively do what they want…
You won’t be able to spot every single company in trouble every time. But with these four warning signs you will be able to avoid the majority of companies that run the risk of falling over the edge.
Here’s to unleashing real value,
Editor, Red Hot Penny Shares
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