Accounting and accounts – Episode 2 – Cash is King

Full disclosure up front – I am a qualified Chartered Accountant. Still a member of the ICAEW.  As such I think there is a story in most set of accounts and this story can be read and understood by a rational reader.

There is a lot of talk about cash being (a) the lifeblood of a business – true. (b) much harder to manipulate than most other parts of the balance sheet – less true.  In line with earlier comments made in this series cash can be easily manipulated for one set of accounts, but gets hard to completely fiddle after a few years.

There are a number of ways that a company can get cash onto its balance sheet for the auditors to sign off on each year.  I will go over a few that you can watch for when reviewing a set of accounts.

1 – The common one and you see this with all sorts of companies is to delay payment of its creditors.  If you do a creditor day calculation and its going up the company is probably delaying payment.  This can work from one year to the next but not indefinitely.  At some stage the suppliers say no more and probably move it back, not to where it was stretched to before the objection but to where the contract says it should be.   Companies who play this game to hard can find themselves creating a big cash crunch.

2 – One you need to be wary of is when a company moves to factoring or invoice discounting.  This on a one off basis generates a lot of cash earlier than a normal debtor as the factor or invoice discounter will allow a large drawing against the invoice (usually in the region of 80%+).  But there are issues; (a) both of these styles of lending work best with fast growing companies, if you don’t grow there are not enough invoices to generate the future cash needed (b) these are both very expensive compared to normal lending (c) banks love them so push them hard.  Without getting into depth there is a legal ruling that makes a loan under factoring or invoice discounting much more legally secure for the bank (d) the factor takes on very little risk as if he is not paid after 90 days he kicks the debt back to the company and reduces the amount that can be borrowed.

I understand why companies factor or invoice discount but to me its a caution as it shows they are not generating enough cash to get into a better lending position. I have also seen a number of occasions when factoring has been used to cover a fraud. Because the bank lends up to 80% against invoices, but often don’t check too hard as they have a stronger legal position and chuck back after 90 days, it can provide an easier environment for extra false invoice generation.

3 – Sale and leaseback.  If a company needs cash it can sell and leaseback many of the fixed assets.  Sometimes this is done for very sensible reasons.  The company wants to outsource the property issues or the car fleet.  But I have seen it done a number of times to meet cashflow requirements.  Get in £5 million today and increase expenses £200,000 a month. I know of one private business that did this with its property, piece by piece, over a 5 year period. In year 6 it run out of property and cash.

4 – Get some co-operative banks involved.  One test the auditor will do is write to the bank asking what the company had or owed on the last day of the financial year.  My understanding is that Polly Peck had 2 banks that transferred funds between them on the last day of the year.  Say at 13.01.  But the bank with all the money in the morning reported its holdings as at noon on the last day.  Whereas the bank with all the money in the afternoon reported its holdings as at [15:00] hrs.  Hey presto £30 million counted twice.

5 – Don’t do maintenance. Or don’t buy fixed assets.  Short term maybe the boiler does not need the annual service or all cars can now be driven for 4 rather than 3 years.  It works once, perhaps twice, but by the third year assets break down.

6 – Sale and fund.  I have seen one example where a company sold its product to other companies with a guarantee that there would be at least a specific revenue stream from the product.  These were £20,000+ items.  Year 1 it went well.  Good sites, everyone happy.  Year 2 the company sold mainly to good sites but had some poor ones in the mix that it subsidised.  Year 3 most sites were getting subsidised.  But as the sale was £20,000 and the payback was 3 years the subsidy was nowhere more than £7,000 and realistically not that.  So for the first three years there was more and more cash in the business.  In fact if the business had stopped growing in year 3 it would have been a very nice private business with a strong market position making good money but flat growth.  As it was it grew and grew and by about year 7 started to pour cash out as all the subsidised sites outweighed the cashflow of new sales.

7 – Cut a deal with debtors. Get cash in quickly by offering debtors a discount for payment before the year end.  This is a particularly good scam if the debtor arises out of long term business.  Say a 3 year contract.  Then you can allocate the discount to either prior years and say it’s not part of this year’s results. Or you call it an exceptional item and write up a note that says it is not part of the underlying business.

8 – Make an acquisition with shares.  Any company low on cash can seek to issue new equity.  But this is generally looked at, and shows that the company is low on cash.  Increasingly it puts management in a bad light.  Which in my opinion is why some companies do an accelerated share issue.  Often this not only hurts the current shareholders through a discounted issue price, but it also means that management don’t issue shares to the current holders but to new shareholders who are less concerned wth the share price before the new issue.  New shareholders happy, old shareholders less so.  One way to try and avoid this is to use your shares to acquire cash by buying a cash rich business for shares.  This seems to be particularly an operation amongst small miners when they can claim they are buying for synergistic and strategic asset reasons, but in fact what they are mainly doing is issuing share for cash.  Shareholders are told they are getting an acquisitive management taking the business forward, what they really have is a dilutive equity issue for cash.

These are all activities that you can read about if you know where to look in accounts on a regular basis.  Certainly not every company, or indeed most.  But they are all activities I have seen in the last 12 months.  To be honest I did wonder about putting a PLC against each of these activities.  However I did not as I do not want to get sued and item 6 is a european listed firm so I do not know what the law is there.    As always I hope this might help a few of you avoid a mistake and always, always DYOR.

By @jpsc01.

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