It is often said that the income statement is a matter of opinion whilst cash is fact. The inference being that the income statement is too unreliable as a measure of value but the cash flow statement is inviolate. The result is an increasing (and largely unquestioned) reliance on discounted cash flows for valuations. The truth is somewhat more nuanced. While the income statement has been around for centuries, the cash flow statement is just a few decades old, having been widely introduced from the 1990s onwards. This means that while there are a multitude of rules that govern what goes into the income statement, rules regarding the cash flow statement are fairly ambiguous, making it far more prone to manipulation. Indeed, the accounting standards bodies stress that the cash flow statement is there as a judge of liquidity and working capital. It is regarded as a poor measure of performance. The US Financial Accounting Standards Body (FASB) specifically prohibits listed companies from including a cash flow per share figure in annual reports, believing it to be misleading.
In our report, COMING UP SHORT: Manipulating cash flows (22 Nov 2017), we explain how consideration settled with debt or equity, rather than cash, is omitted from the cash flow statement. This might include finance leases (a form of debt) to pay for large assets, such as aircraft, or share-based compensation for employees. In both instances, this will lead to free cash flows being over-stated, and it should be adjusted in order to derive a more representative number.
While finance leases or share-based compensation are fairly standard practice in some sectors, we are particularly concerned about companies which are likely gaming the cash flow statement rules in order to flatter their liquidity position. For example, when companies engage in structured payables, their banks will settle the amounts owed to suppliers directly. This is similar to paying your bills with a credit card. While the accounting firms argue that these entries should be included in the cash flow statement, some companies have argued that they are non-cash items, such as Sinopharm. As such, operating and free cash flows will be over-stated while financing activities under-stated, thereby flattering their liquidity position. For more information on Sinopharm, please refer to our in-depth report, SINOPHARM (1099 HK): Not what it seems (11 Jul 2017). Fortunately, from 2017, annual reports prepared under IFRS will include a reconciliation of debt, which will flag companies hiding debt-based payments.
In order to spot companies making debt-based payments, we have custom-designed a model which attempts to reconcile the change in debt on the balance sheet with that recorded in the cash flow statement. If the unreconciled amounts are greater than 5% of both sales and total debt, a red flag is triggered, as shown in Figure 24. Between FY12 and FY16, the face value of Sinopharm’s debt increased by RMB19.6bn, whereas it fell by RMB2.5bn according to the cash flow statement.
Sinopharm triggers a red flag in each of the past five years which is extremely rare. For example, we downloaded data from over 7,600 companies globally and only 81 companies triggered a similar number of red flags, an incidence rate of only 1.1%, Just 32 of these companies had no reasonable explanation, such as an acquisition or finance lease, to justify our inability to reconcile the numbers.
Over the past three years, we were able to reconcile the debt of 56% of all companies in our global sample. We were unable to reconcile the debt of 28% of companies for one year, 12% for two years and just 4% for all three years. In Emerging Asia (which is dominated by Chinese listed companies), we were unable to reconcile the debt of 5.5% of all companies compared to just 1.8% in North America.