Unmasking business shenanigans

I have recently pointed out that one of the warning signs that a business is facing issues is when core revenue, ie revenue from the main business lines, is down but profit is up.

Why the combination? Why not simply flag a drop in core revenue? Because it is normal for revenue to fluctuate – especially in a challenging economy. But if revenues go down and profit goes up, it means the business has miraculously had a major increase in non-core revenue or, worse, has made large cuts to expenses.
Large jumps in non-core revenue are rarely sustainable. They usually come from either re-valuing assets, an exercise that does not affect cash flow nor is it recurring, or from the sale of an asset at a price higher than it was held on the books, which helps cash flow but is non-recurring and may reduce income-generating assets.

On the expense side you have actual cash expenses that are reduced, usually employee compensation or number of employees, but this can also include things such as rent. These have a positive cash-flow effect but are limited in the number of times they can be done, not to mention that it can affect revenue generation by losing employees or reducing morale.
The red flag is when non-cash expenses change drastically, such as depreciation, amortisation and impairment charges. This is a red flag because it is relatively easy to massage these numbers, plus it has no impact on cash flow.

All of this, plus the potential for management to intentionally report the financials so as to use non-recurring and usually non cash items to mask a revenue drop and still show a profit increase, makes for a warning sign. So if you see core revenue drop but profits increase, you might want to look at some of the above items to better understand what is going on with the company.

External financial transactions can also be misused. Repurchase agreements as well as sale and leaseback agreements can be a warning sign. Often such agreements are quite useful. However, since they involve the initial sale of an asset, which generates a large one-time revenue, followed by either a stream of smaller payments or one large payment far in the future, these instruments can be misused to portray a huge revenue increase today with the related costs masked by pushing them into the future.
Such financial wizardry can create bigger problems when the asset is sold at a negotiated price, ie there is no publicly independent means to verify the price as would happen with a used aircraft, in which case it is possible that the initial sale price is much higher than market prices, resulting not just in increased revenue but a large increase in profit. This results in a large loss when the aircraft is sold back to the original owner or even earlier if the auditors or board figure out what is happening.

Away from financials there are several other warning signs. Multiple acquisitions, for example, as each time an acquisition happens the financial statements change due to the inclusion of the new entity and board directors might not have the skill and certainly won’t have the time to figure out what’s going on. A related method is restructuring. A simple restructuring would be merging or splitting departments, which creates some obfuscation.
A deeper level would include the concept of a consolidated asset. The following explanation is not exact but is meant to convey the idea. A consolidated asset is one that is deemed under the control of the parent. Normally an asset, such as 20 per cent of an operating company, is held on the balance sheet with only dividends paid by the asset included as revenue in the income statement of the parent. However, for a consolidated asset the actual underlying assets of the subsidiary are included in the balance sheet of the parent and the pro rata income of the subsidiary is consolidated in the income of the parent.
So if you hold 100 per cent of an asset that is losing money and you sell 60 per cent of it and it deconsolidates, then your assets increase, possibly decreasing your leverage ratio but more importantly your expenses drop more than your income on a recurring basis and you get a one-time boost to income due to the actual sale. It takes a lot of analy- sis in the notes of a company to catch this.

A good indicator of whether such transactions are purely commercially motivated or not is how transparent management is about them in their presentations and press releases. If management openly admits to and explains large one-off transactions then it might indicate purely commercial behaviour.

If not, caveat emptor.