Ten signs a company's in trouble - MoneyWeek Investment Tutorials

it was a great story Southern Cross was the care homes operator that basically floated in 2006 having been owned by Blackstone private equity and this year basically ceased trading so a fairly catastrophic period between 2006 and this year something went horribly wrong and quite a few investors might have said well how could we know I mean I mean the story was fantastic this was a business that basically played on the idea that we're all getting older we all need to look after ourselves in old age there's a shortage of care homes in the UK it's something that government's interested in and funds what's not to like more and more old people shortage of quality care homes our government pushing care into the private sector surely as at one point the UK's biggest care home operator this was a one-way bet well it was a bad one and a lot of investors missed presumably at least at least ten big clear warning signs that you could have picked up from the account pretty much anywhere from 2006 onwards that all was not well yeah fine once a profits warning was flashed up in 2008 sure the shares plunged and then recovered but these red flags were there the whole way through so what I'm gonna do is to use Southern Cross is a good example of why PDS though it seems looking at the accounts can pay dividends it's a meaty document there's a lot of detail buried in there but if you're prepared to do at least some basic checks you can pull out some of these red flags from any set of accounts potentially at Southern Cross this case they were kind of flashing red really quite quite glaringly obviously okay it's what are they so let's go through ten ways you can build up a picture all is not well at a firm now you might say well hindsight's a wonderful thing the point is you should act on these fears if you go through these ten red flags and just go well the story still stacks up so sod it I'll stay invested well more for you um so when are these red blacks going to start with some that basically come from the accounts but as we go through I'll flag up one or two other obvious ones you could have picked up just by reading the media or just by following the story as it unfolded okay so care homes business growing fast in theory and taking on more and more old people who need to care in their old age big chunk of their business and they sent funded by the government and obviously a private money accounting for the other twenty right so what were the red flags first of all you need a basic understanding of profit and also counts and balance sheets now for anyone who doesn't have a basic understanding of those two key statements I've got two videos what is profit and what is a balance sheet strongly recommend you take a look at those but in a nutshell the profit and loss account is the one that everyone looks at that's the one the directors want you to see and there's a red flag sitting right smack in the middle of southern crosses profit loss coucher talk about the moment the balance sheet is actually more important to say that again the balance sheet is more important in fact given a choice between the profit and loss account the balance sheet and the cash flow statement if someone said which one should you pay most attention to the answer is the balance sheet and I'm backed up on this by Sir David Tweedy okay if you don't know that is look him up chairman at the International Accounting Standards Board the accountants accountant knighted for his contribution to accountancy that's a lot of account Z so he's always said investors should pay more attention to balance sheets so you don't have to take it from me take it from him profit and loss accounts of course are easier to read and that's where the directors would probably rather you focused your time so profit not account snapshot op the last 12 months in business terms what are we sold what did it cost us what do we walk away with in terms of a profit the balance sheet is a snapshot of what in theory the company is worth in accounting terms at any one point in time and the crucial thing about the balance sheet is it tells more of a story it's cumulative it reflects all the decisions taken by the directors to get to where they are at the point the balance is published it's not a one-year snapshot which the profit and loss account is okay so what could you have discovered from the balance sheet of Southern Cross if you've been looking now the balance sheet the profit loss account the cash flow statement are buried about halfway through the accounts you need to get the financial statements and trot through them I'm going to be quoting your number from the 2008 accounts that's the year ending September 2008 but frankly most of these comments would have applied to any set of accounts you've picked up the Southern Cross between well frankly from the floatation in 2006 so the fact I picked 2008 which happened to be the year of the profits warning and so on is by the buyer in some respects okay so red flags from the balance sheet number one there are 10 but I'll go through them fairly quickly number one a huge goodwill figure all right now goodwill is a funny old asset it's intangible at the top of a balance sheet you list your long-term assets some of them you can kick like buildings and cars some of them you can't like goodwill the problem with goodwill was in Southern Cross its balance sheet it was twice shareholders total equity it was a damn big figure for that kind of business that reflects the fact that Southern Cross went on a buying spree expanded rapidly after it was floated in 2006 that in itself is a sort of red flag rapid expansion immediately post float using cheap money is a warning sign but a huge goodwill pic like that a problem with goodwill is this if the value of the assets you're carrying suddenly drops you're going to take a huge hit too elders equity and the business that's got goodwill of in effect twice shareholders equity makes me nervous straight away okay it's not enough by itself but it makes me nervous there's red flag number one from the top of the balance sheet moving down the current ratio now plenty of people hate the current ratio they're analysts who would slag it off and say it's not representative but here it does tell a story what a current ratio does is it asks the question basically can we afford out of our short-term assets to pay our short-term liabilities now again I have done a video on balance sheet if anyone is a little bit lost is a snapshot in other words you know is what we've got short-term in assets enough to cover our current liabilities and here's the point even if you're not sure that ratio is exactly a Southern Cross in a fallen by 2008 to really a pretty dangerously low level in other words current assets only represented half current liabilities this was a business in trouble and sure enough if you've read through than a background notes we're around a time at this point where there were renegotiations going with the bank over debt facilities and all kinds of other red flags flying around this time but the current ratio of less than well you know certainly less than about one in a business like this is a red flag and of that current ratio of the current assets the business had cash was tiny so low current ratio clear cash flow problems so there's red flag number two red flag number three gearing get to equity now I've done a video on leverage and that's worth a look if you haven't seen it already but basically this was a business where the total debt being carried was over three times total shareholder equity and that is one heck of a lot of debt to carry in anyone's books it's no good running the argument we're expanding fast we can justify borrowing that is an awful lot of debt to carry relative to shareholders equity no surprise that a debt renegotiation was on the cards so so far big asset in the balance sheet which we don't really understand goodwill to low current ratio three very high gearing and what was on the balance sheet wasn't the only story off-balance sheet there was a five billion horror story lurking now in fairness to find this you needed to troll all the way back to note 34 in the financial statements now but I'm you get to about note 34 most people lost the world to live so quite a few people would have missed it but basically to cut a long story short this was a business signing leases committing it to pay rent that would be raised almost annually according to an agreed chedule with the landlord over 30 years that's almost a sort of operational suicide note if you like and the liability to which the business was committed at the balance sheet date not all payable at once in fairness was enormous dwarfed anything else on the balance sheet in Venice it was off the bad sheet in other words it was it was hidden but always check for these it does involve I'm afraid rooting through some notes at the back of the accounts someone once said the best way to reset the count is backwards that's because the stuff the directors really don't want you to find the will be at the back make sense so there is red flag number four red flag number five plunging cash flow now it's a couple of ways looking at cash flow cash cover is quite a good way you can look at the relationship between profits in the profit not scale and the cash being generated there is a difference between those two known as accruals by accountants but fundamentally you need to check that a business that's declaring trading profits is turning it into cash plenty of small and large businesses go bust because basically they book a lot of sales but then failed to collect cash from customers key customer for this business the government local authorities they're not famous for their ability always to pay on time and that started to have an impact on Southern Cross quite early and basically of course the depth sell if you will be negotiated you can say well we know that now that that's hindsight but not really essentially cash flows we're not keeping pace with profits and the overall level of cash for business at this size has a kind of safety float was dangerously low so there's red flag number five red flag number six is the directors favorite earnings number now this one always makes me nervous well it doesn't even it doesn't really matter if you're not sure a bit Diaries there's a video on that actually what what it is is less important than the fact the directors felt the need to return shinto it in the profit and loss account it wasn't good enough that companies have to report gross profit operating profits statutory numbers all know Southern Cross decided this was a better measure of how they were doing course it was because this is the one they can show going up all right so adjusted a bit dial that's earnings before interest tax depreciation and amortization yeah take a couple of years 2007 2008 the trend is upwards but compare it to a more normal profit bigger like operating profit almost any other profit the UK dimension and the picture was less rosy and I'm always wary I'm afraid to say I'm always a bit cynical when directors say no no no you don't want to look at the numbers that we have to produce by law you know look at this is our special profit think we're a special type of business this is the one you want to look at because it will be the one that they can show you going up and probably as a bonus they may have even in some businesses linked the directors remuneration to it great so you design a scheme guaranteed to make you rich of course from a shareholders point of view you know just watch out for this the directors deliberately steering you towards the number they think you should be looking at ask yourself the question why they're doing that um so that makes me know that's a red flag in its own right I think enough said really so other red flag so one two three four five six other red flags now these you didn't need to be an accountant to have a look at let's take a couple look at those key management changes any business that loses its finance director especially a business that this big and this high-profile that's a red flag any business that loses its CEO because after all why is it happened either they were brilliant and they've been poached well that's not good for this business or they were frankly rubbish and they've been dumped and that's not good for the business either so rapid turnover at a senior level in the aftermath of an IPO is a dreadful warning sign so red flag and there were plenty of examples of senior management changes through 2006 2011 but perhaps the most obvious one was the loss of the-- the finance director about midway through that period now as if that wasn't enough of a clue directors dumping shares end of 2007 some of the most senior directors in the business basically dumped huge amounts of shares on the market so the words post flotation they held on to their shares and then fairly quickly dumped them that's got to be a red flag if the people on the inside don't even believe their own story why should you now I know for after that 2007 sale yes there was some share buying after that too but essentially not on anything like the same scale um so what do we got it 1 2 3 4 5 6 7 8 I mean how many do you need so let's throw in a couple more for good measure and there are more than 10 these are the 10 Biggie's um the business model was flawed right from the start arguably Blackstone got it right actually they owned the business between 2004 2006 and we're accused of dumping it on the market having wrecked it oh that's not fair it was wrecked after that so when I say the business models flawed I don't mean the provision of care is flawed but you've got over reliance I'm always wary of businesses that only essentially have one customer and that customer was the UK government the assumption seemed to be that fees paid to caring providers would always rise as a bottomless pit of money available that would just flow in from local authorities no questions asked because they were so grateful to these um private health care providers for taking all these old people off their books if you like well having only one customer means if that customer hits problems or changes its strategy or changes its policy you're stuffed and given around 80% of southern crosses business came from government and local authorities that should have been enough to make anyone frankly quite nervous okay any more red flags yes rapid expansion people say to me well that's a good thing isn't it Tim that means the business is growing by the way lots of lots of places you can find it so I'll explain that in just a moment to wrap up rapid expansion no expansion needs to be controlled it needs to be at a certain speed otherwise the wheels come off very quickly signs the wheels were coming off very quickly okay what I mean by rapid expansion is basically the number of care homes once the business floated shut up in a matter of just a few years by 30% that's an awful lot of new property and premises to manage basically the business was growing the number of care homes and science that all was not well came from what's called the operating financial review that's at the front of the accounts there is a bit of a story and a few numbers in there so signs things are not well and you could pull these all out D counts number one rent cover was dropping what that means is the business was basically signing having sold off quite a few freehold properties that used to own the business was busy signing long term rental deals with landlords for new care homes 2530 years so that's a commitment to pay rent the question you got to ask yourself is if I'm committing myself to pay rent over a long term period what income of my expecting and here's two problems both flanking the accounts for anyone looking for these problems number one occupancy rates started to fall very bad news when you've just signed a fixed rent commitment and the cover as it's called rent cover that's the relationship between expected income and expected rent started to drop as management got less and less choosy if you like about the kind of deals they were signing so what had been a fairly careful program of Managed expansion pre-2006 turned it with an avalanche afterwards and the wheels started to come off pretty quickly falling occupancy rates basically bed capacity growing faster than sales all these things a sign that rapid growth was not being managed correctly so growth is good rapid growth can be good but the business has got to be delivering the underlying profits and cash flow to justify it so Southern Cross ten red flag for a more frankly but these are the big ten some of them very easy to pick up for the picture but basically comes together from Southern Cross is there was plenty going wrong and it was going wrong from quite a long way back and a cursory reading the accounts would have told you that

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Published: Thu Jul 28 2011