A Fake Cash Flow Fraud is a company that fakes its sales and profits, hiding the evidence in non-production assets such as cash or prepayments. This manifests as a highly profitable company generating copious quantities of free cash inflows with large liquid assets, such as cash. Fake Cash Flow Frauds will concurrently trigger our Excess Capital Raising flag.
In our report, FAKING CASH FLOWS: And How to Spot it (10 May 2017), we devised a system to highlight possible Fake Cash Flow Frauds. To create our system, we put 85 past accounting frauds through our Accounting and Governance Screen to work out any commonalities. Our analysis showed that they shared a number of features which we refined into a four-point scoring system:
- 1 point for being overly profitable (in the top quintile): Companies which are overly profitable relative to peers, as defined by operating margins or returns on production assets (operating profit/PPE plus inventory). A full 98% of frauds recorded EITHER a very high operating margin OR return on production assets.
- 1 point for non-production assets: A build-up, or high level, of non-production assets (total assets less PPE plus inventory) relative to Cost of Goods Sold (COGS). The single largest problem with fake cash is that it is difficult to extract from a company: it can’t be paid out as dividends if it doesn’t exist. As such, it needs to be parked on a company’s balance sheet, normally as a non-production asset, such as cash or prepayments. In our sample of Chinese frauds, 87% of companies recorded EITHER a high level of non-production assets/COGS in the top quintile relative to industry peers OR an unusually fast build-up of non-production assets/COGS over one year.
- 1 point if dividends are less than 30% of profit: If a company is generating fake cash flows, it is unlikely to be able to pay much of a dividend. As discussed above, pure fake cash flow frauds find it difficult to pay dividends because the cash doesn’t exist. Indeed, 92% of our fraud sample had a dividend pay-out ratio below 30%, and 71% paid no dividends at all.
- 1 point for fraud like characteristics: If a company scores two or more of the following: an obscure auditor; a different country of incorporation to domicile; short term debt is more than 75% of total debt; operates in a high risk sector prone to fraud. Around 94% of our fraud sample triggers two or more of these four criteria compared to just 32% of companies globally.
Around 73% of historic frauds scored a full four points, compared to just 2.9% of all listed companies globally. However, in Hong Kong and China this incidence rate was far higher, at 5.6% and 6.9%, respectively. Stripping out Hong Kong and China, and the global incidence rate was closer to 1%. In summary, no matter what technique we use to gauge the quality of financial statements, Hong Kong and China appear to come out worst.