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.
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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.
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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.
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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.
Sabah Al Binali is an active investor and entrepreneurial leader with a track record of growing companies in the Mena region. You can read more of his thoughts at al-binali.com
business@thenational.ae
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Red flags
- Promises of high, fixed or 'guaranteed' returns.
- Unregulated structured products or complex investments often used to bypass traditional safeguards.
- Lack of clear information, vague language, no access to audited financials.
- Overseas companies targeting investors in other jurisdictions - this can make legal recovery difficult.
- Hard-selling tactics - creating urgency, offering 'exclusive' deals.
Courtesy: Carol Glynn, founder of Conscious Finance Coaching
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The years Ramadan fell in May
Avatar: Fire and Ash
Director: James Cameron
Starring: Sam Worthington, Sigourney Weaver, Zoe Saldana
Rating: 4.5/5
Have you been targeted?
Tuan Phan of SimplyFI.org lists five signs you have been mis-sold to:
1. Your pension fund has been placed inside an offshore insurance wrapper with a hefty upfront commission.
2. The money has been transferred into a structured note. These products have high upfront, recurring commission and should never be in a pension account.
3. You have also been sold investment funds with an upfront initial charge of around 5 per cent. ETFs, for example, have no upfront charges.
4. The adviser charges a 1 per cent charge for managing your assets. They are being paid for doing nothing. They have already claimed massive amounts in hidden upfront commission.
5. Total annual management cost for your pension account is 2 per cent or more, including platform, underlying fund and advice charges.
World ranking (at month’s end)
Jan - 257
Feb - 198
Mar - 159
Apr - 161
May - 159
Jun – 162
Currently: 88
Year-end rank since turning pro
2016 - 279
2015 - 185
2014 - 143
2013 - 63
2012 - 384
2011 - 883
Vidaamuyarchi
Director: Magizh Thirumeni
Stars: Ajith Kumar, Arjun Sarja, Trisha Krishnan, Regina Cassandra
Rating: 4/5
Mercer, the investment consulting arm of US services company Marsh & McLennan, expects its wealth division to at least double its assets under management (AUM) in the Middle East as wealth in the region continues to grow despite economic headwinds, a company official said.
Mercer Wealth, which globally has $160 billion in AUM, plans to boost its AUM in the region to $2-$3bn in the next 2-3 years from the present $1bn, said Yasir AbuShaban, a Dubai-based principal with Mercer Wealth.
“Within the next two to three years, we are looking at reaching $2 to $3 billion as a conservative estimate and we do see an opportunity to do so,” said Mr AbuShaban.
Mercer does not directly make investments, but allocates clients’ money they have discretion to, to professional asset managers. They also provide advice to clients.
“We have buying power. We can negotiate on their (client’s) behalf with asset managers to provide them lower fees than they otherwise would have to get on their own,” he added.
Mercer Wealth’s clients include sovereign wealth funds, family offices, and insurance companies among others.
From its office in Dubai, Mercer also looks after Africa, India and Turkey, where they also see opportunity for growth.
Wealth creation in Middle East and Africa (MEA) grew 8.5 per cent to $8.1 trillion last year from $7.5tn in 2015, higher than last year’s global average of 6 per cent and the second-highest growth in a region after Asia-Pacific which grew 9.9 per cent, according to consultancy Boston Consulting Group (BCG). In the region, where wealth grew just 1.9 per cent in 2015 compared with 2014, a pickup in oil prices has helped in wealth generation.
BCG is forecasting MEA wealth will rise to $12tn by 2021, growing at an annual average of 8 per cent.
Drivers of wealth generation in the region will be split evenly between new wealth creation and growth of performance of existing assets, according to BCG.
Another general trend in the region is clients’ looking for a comprehensive approach to investing, according to Mr AbuShaban.
“Institutional investors or some of the families are seeing a slowdown in the available capital they have to invest and in that sense they are looking at optimizing the way they manage their portfolios and making sure they are not investing haphazardly and different parts of their investment are working together,” said Mr AbuShaban.
Some clients also have a higher appetite for risk, given the low interest-rate environment that does not provide enough yield for some institutional investors. These clients are keen to invest in illiquid assets, such as private equity and infrastructure.
“What we have seen is a desire for higher returns in what has been a low-return environment specifically in various fixed income or bonds,” he said.
“In this environment, we have seen a de facto increase in the risk that clients are taking in things like illiquid investments, private equity investments, infrastructure and private debt, those kind of investments were higher illiquidity results in incrementally higher returns.”
The Abu Dhabi Investment Authority, one of the largest sovereign wealth funds, said in its 2016 report that has gradually increased its exposure in direct private equity and private credit transactions, mainly in Asian markets and especially in China and India. The authority’s private equity department focused on structured equities owing to “their defensive characteristics.”
