When any investor chooses to invest their hard-earned money in equities, they are of course looking for worthwhile returns over the long run.

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One of the most basic principles of investing is ensuring that the company you buy into actually makes money, instead of just having a large sales or revenue number. As a shareholder, what is the point of having a huge revenue number if nothing ends up at the bottom line?

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Recently, we reviewed a company that had caught our eye when it showed very encouraging sales numbers year after year. However, upon digging deeper, we realised that this company was in fact burning much more cash than it actually earned. You may not think that this is possible, but it is, in fact, very common.

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As we reviewed further, we could see that this company had a high amount of receivables. This is an area of concern as it means that the company may think that it is going to receive these payments, but in fact, there is no guarantee that it will be able to collect the money. And these receivables can rapidly add up.

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For this company that we looked at, the amount of receivables was larger than the full year of revenue. The revenue was US$78mil for the financial year, but they had already racked up receivables of US$111mil. We also read from the accounts that the company consistently writes off at least 7% as bad debts every year.

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Clearly, this is not a good sign. For the more astute investors, they know that this is a red flag for potential accounting irregularities. Of course, a high level of receivables is not necessarily evidence of wrongdoing but it is an indication that there could be some irregularities. Giving the management the benefit of the doubt, at most, what we can assume is that they have not been shrewd in managing their credit risk at all.

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We also determined that there was a large number of dormant customers listed in their database. So, although the company boasted a half a million customer base, so many of the customers were completely inactive. Thus, the records of the large customer base was more of a marketing gimmick than a real value-added client base.

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Furthermore, we read that the company had conducted an acquisition two years ago which was settled partly in cash, and partly in shares. From our determination of the deal, we could see that the company carried out the acquisition in order to prop up their revenue numbers.

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What became glaringly obvious though, was that once the acquisition was completed, the directors’ remuneration increased by a hefty 47%. Since the acquisition, the profit has now dropped by a massive 65%.

 

Thus, it would seem that either the acquisition was not profit-accretive and that a bad decision had been made, or possibly, the losses from the past are starting to be thrown out, since it is nonsensical that the receivables would have ballooned to a level where customers owe more than 9 months. How could the credit controls allow the receivables to reach a multi-million number?

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Given the company’s extremely weak management of receivables and its constant purchase of information technology, the company continually needed to raise cash. We discovered that they achieved this by issuing more shares, which of course, is the first way to dilute your earnings per share.

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The only saving grace about this company was that its valuation is extremely cheap, at a PE of around 3, assuming that the EPS was real. There could have been more skeletons in the earnings numbers.

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We then tried to call the company to get a complete understanding of their operations, and to make sure that we were not making any wrong judgements given what we had read. We then discovered that the entire finance team was not even based in the company’s headquarters. No wonder the receivables management was so weak, since the department that was responsible for ensuring robust collection was not centrally empowered. We also discovered that the acting financial controller only had 3 years work experience!

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This final phone call led us to the conclusion that the underlying business was clearly in a muddle, despite the fact that the PE valuation was cheap, the business was in a growth sector, and the sales numbers looked strong. After completing the due diligence exercise, we decided that this was yet another company that we had to walk away from, given the many issues hounding them that could lead them directly into the doldrums.