Warning Signs 01 (Oct 08 - Feb 15)

[sidney]

FerrorChina

Red flag 1 - Solvency of firm

Acid test ratio, i use cash + Fix D + recievables + ALL current liabities = 0.66

For every one dollar owned, 66 cents is used to support payment, Current Liabilities means creditors demands payment inmediately usually a matter of months. Under current assets, Inventories and land rights is left out due to the valuations are based on book values. In the real world, market valuation of inventories and land rights are more accurate. And given in the view of fire sale both inventories and land rights would be significantly lower than being reported in balance sheets.

Red flag 2 - Goodwill = not too good for shareholders
Goodwill, as an non-current assets makes up More than Half of non-current assets, in fact more than its Plant, property and equipment! Did management overpaid for acquisitions? My defination of Goodwill is how much you are willing to overpay for something you desire.

Red flag 3 - Sharp increase in short term borrowings and long term debts

Did anyone question why there is an 4X increment of banks loans and payables compared to 2006? Long term bank loans also increase 2.5X compared to 2006. Borrowings were mainly funded to expand P,P,E + inventories and goodwills. Goodwills is grossly overpaid, i think.

Red Flag 4 - Cashflows from operations

CFO generated from operations in 2006 is 240,519,000 rmb, CFO in 2007 is 157,723,000 rmb. Cashflow from operations decreases 34.5%. This means that firm is less profitable after acquring assets for expansion. And ~ after paying high interest which bleeds the company, the firm actually suffers net loss of cash of 21,698,000 rmb as of 2007. How long can they sustain?

Red Flag 5 - Cash coverage for interest payments

Using EBIT + Depr / Interest

412,222,000 + 145,100,000 + 35,206,000 / 145,100,000 = 4.08 times
The firm only earns enough cash to service its interest loan 4 times over. Service loans is already a huge burden... therefore will surely faced cash crunch when come to pay current liabilities, given its small cash pile.

Red flag 6 - Pay dividends even when company is unprofitable

Unfortunately, investors who dun read financial statements are "quite contented to get paid". Laymens will assume companies paying dividends are financially sound. However, increased in net cash from 2006 to 2007 is FUNDED by bank loans. Therefore, firm is loaning money from banks to pay shareholders.

Red Flag 7 - Reading graphical record net profits earned and ignore under underlying reports like cashflows, income statements and balance sheets which tells the picture clearer. Especially CASHFLOWS.. i repeat. Cash, cash, cash, cash, cash, cash, cash, cash, cash, cash, cash, cash, cash, cash, cash, cash, cash, cash, cash, cash, cash, cash, cash, cash, cash, cash.

Laymen see graphical net profit increases shoot up, very satified. This in fact, is very misleading. Up till now, i cannot find companies reporting decreasing net profits every year. (i admit, i also get a high when company report record profits) What they should be concern is

In balance sheets
a) What is the cash levels + other liquid assets. ( x inventories)
b) Any significant increase in assets / liabilties / equities? Why is that so... and is it comfortable to look at these inflated figures?
c) Acid test or current ratio should be perform to asset the firm's solvency before buying stocks. I admit, i didn't bother to..

In financial statements
a) Try not to get carried away even if the company reports increased in profits.
b) Look for for large figures... especially its COSG, expenditure.

In cash flow statements
a) Very important is to read its CFO. If CFO is negative, company is unable to generate enough cash from its core operations to fund its day to day operations.

b) Cash Flow from Investing is usually negative, due to investments in fixed assets, but look out for big cash bleed and question their buys.

c) Cash flow from financing. If cash is raised here, does it comes from shareholders or from debtors?


Ok done.. there are many more red flags, but i feel beyond my level to comprehene... so will add if i learnt something more! Forumies pls comment on my mistakes if i calculate wrong or pluck wrong figures. Or if i misrepresent any statement, pls inform me so that i will / edit or remove this thread immediate for the benefits of others.

Lastly, investors are required to do their own diligence in research and not rely on my studies or other 3rd parties sources.. especially (brokers / analyst's research) ... if you haven learnt the lesson... Rule no1 is: they can be wrong too... so can i. So dun believe everything i say. Caveat emptor!

[kennynah]

winston sir!!! permission please....

[winston]

Ha ha .. No need permission to start a new thread lah.

Sid, this is a very good topic. How about changing the title to "Warning Signs" or something like that..

Take care,
Winston

[la papillion]

Sidney, a very good article you posted there! Well done

[sidney]

Dear winston, how about warning signs of soon to be distressed companies? I'll leave it to your discretion to change

[sidney]

China Printing & Dyeing Holding

Another distressed company

Annual reports 07-

Red flag one - ROE and key financial highlights

Over simplifed annual report. Key financial highlight diverts attention to what is immaterial to investors looking for a firm's solvency. Yes, key ROE growth is improtant. One must note that ROE can be explained by dupont, which is ROE = Profit margin x Total asset turnover x Equity mutlipler.

PM is a measure of every 1 dollars of sales, how much net income is generated.
TAT measures asset usage efficency
EM measures financial leverage, which is using debt to increase earnings

ROE can be inflated when profit margin, and/or asset usage is low by inflating equity multipler. This explains why investors got caught assuming increasing ROE Y-O-Y equates to more growth, more earnings and financial stability. What is unrealised is leverage drives the higher returns for shareholders, not asset efficency or core operations growth (increase in profit margin).

Simplified financial reports ~ only 25 pages include chinese text somewhat reveals to investor there is not much puff left on the cirga butt. This is the shortest annual reports i have ever seen, and... (no offence... just personal opinion!) i feel any Uni student studying finance can come out with this kind of report in 1,2 days. Although reading 200+ pages of annual reports is intimidating and very distracting... there are plenty of things to dig.

Too little infomation is revealed on the financial statements. Annual reports appeared truncated. Upon seeing 2006 reports, financial reports are found to be posted seperately.

Red flag 2 - Use of IPO proceeds

Management exceed cost for expanding pdn capacity by 10%.
R&D is cut by 90%
Sales distribution is cut by 50%.

Cut in Sales distribution is a kind of retribution to bottom line, since the decreased in sales distribution funding translate to decreased growth in top line.

Cut in R&D often foreshadows more trouble is yet to come as firm may struggle to conserve cash for its working capital needs.

Red flag 3 - Focus on net profit

A firm which is profitable does not means it is cash rich. In fact, it is bleeding cash. Think: Is a man earning 5k a month but in 10k debt a rich man? Or a man earning modest income of 2k, yet is able to save 200dollars a month consistency more financially secured? This applys to firm.

Red flag 4 - Where, where, where?

How come no b/s, I/s and CF statements in annual report? This is october 2008, how come full financial report 2007 not found in SGX? Is this considered compliance issue?


Quarterly reports till Q2 2008-

Red flag 5 - Cash & cash equivalents (see note 1)

The first thing to do is not to see numbers, but to see note 1! Although current assets of Cash & cash equivalents is apx 500,000,000 rbm, note 1 indicates apx 385,000,000 rmb is collaterised by banks. So effective cash is left apx 114,000,000 rmb.

Using Acid test ratio to determine its solvency,
Current assets ( ex inventories) / Current liabilities = 1. No good in short run.

Using Adjusted acid test ratios - (effective cash balance + other current assets) / Current liabilites = 0.6 lagi worse. Cham.
Every 1 dollar debt is supported by 60cents of asset.

Red flag 5 - Short term debts to be repaid

Already stated, short term debts to be repaid <1 year exceed exceeded its effective cash balance. Cash has to be funded by issusing equities or through debt borrowings.

Red Flag 6 - Cash flows statements

Cashflow from financing
Interesting to observe the trend in repayment and borrowings. For every 1 dollar returned, firm reborrowed apx 1.1 dollars. Therefore, not unusual to observe the interest servicing expenses increases.

Cashflow from operations
Very stress to observe core operation earnings can be so volatile. This is more like a free fall in earnings! Increased in debt servicing has a very significant impact.

*Forum readers advised to do their own due diligence as my assessment may be inaccurate, biased. If any statements posted is inaccurate kindly inform me so tat i can reedit or remove for the benefits of forum readers.

[sidney]

Sidney, a very good article you posted there! Well done

Dear La pap thanks for the praise, here is the posting... i hope it helps, although relatively incomplete. As for the missing key personnel...

Character & accountability of a person is also a gauge. But we can only know in hindsight, when they gone missing..

[helios]

As for the missing key personnel...

Character & accountability of a person is also a gauge. But we can only know in hindsight, when they gone missing..

yeah, i can't believe that the independent directors [local singaporeans] knew "Nothing" about the 'wanted persons' whereby during an ipo-event, they were the invited in the first beginning by these China businessmen ... & these people could be lawyers/ accountants by professional ... !

According to SGX listing rules, there must be at least 2 independent directors on each board. Also, the voluntary code of corporate governance says that one-third of the board must be independent ... & how 'hard' is it to establish independency relationships in a China operated macro-environment?

[helios]

on another level of foresight, it is best to 'track down' the profile of independent directors ...

Based on the SGX website, Mr Hoon Tai Meng, the managing partner of law firm TM Hoon & Co, sits on the boards of six listed firms such as Intraco and Heshe Holdings.

Mr Lim Lee Meng, the senior partner of medium-sized accounting firm Chio Lim & Associates, sits on six boards including those of Tye Soon and Suntec Reit.

Member of Parliament Ong Kian Min sits on 10 boards including those of OSIM International, BreadTalk, Penguin Boat International and GMG Global.

Another MP, Dr Wang KaiYuen, sits on 12 boards, including his latest appointment, with troubled logistics company Airocean.

His view about having a fixed number of board seats is that it 'all depends on the individual and how he manages his time. But someone who is familiar with the corporate governance code in Singapore should be able to realise if he has time to meet those commitments'.

Dr Wang added: 'It also depends on the companies in his portfolio; some are very stable, others require more attention.'

[winston]

One of the early warning signs that I look at is the resignation of the CEO, CFO or any Directors..

Do they know something that you dont ?