When someone tells me ‘cash is king’, I am immediately tempted to ask for a DNA test: where did the cash come from? Can we be sure about its parentage? And, most important of all, to whom does it belong? Royal lineage is no guarantee of authenticity.
This may sound unnecessary – cash is cash, right? – but this simple headline can disguise a multitude of sins. And searching for the answers can be frustrating.
Let’s start with ownership. I was once tasked with valuing a complex conglomerate that was considering flotation. The company owned a 60% stake in a shipyard that had a large cash pile; in other words, 40% of the cash belonged to other shareholders and not to the parent company. There is no requirement to disclose cash in subsidiaries with large minorities, so I had no idea just how much of a problem this was.
It got worse. It transpired that the shipyard had received advance payments from customers. In other words, customers were funding the working capital up front to help the shipyard stay solvent during long and complex projects.
What’s real?
Valuing advance payments is a remarkably slippery process. The cash is real, in the sense that it is in the company’s bank account, but it is already spoken for. It will be used to pay suppliers and employees, and at the end of the contract most of it will be gone. On that basis, the cash does not belong to shareholders. It is like a solicitor’s escrow account.
IFRS disclosure on advance payments is ineffective and unpicking the tapestry is often impossible
However, some companies run with a permanent level of advances as new contracts replace old ones. One can then argue that the advances are just negative working capital and that the inflated cash balance reflects economic reality. Mandatory IFRS disclosure on advance payments is ineffective and unpicking the tapestry is often impossible.
The interesting part comes when you sell a subsidiary with material advance payments. I knew a German company that sold its plant engineering business for the €400m I had confidently forecast. Unfortunately, the new owner took €400m of advance payments at the same time, so the apparent transaction price was zero. I would have stripped out the advance payments earlier, had they been apparent in the accounts.
Advance payments can also cause problems when orders dry up or industry norms change. A sharp fall in customers willing and able to pay in advance can cause liquidity problems.
In a perfect world, I would look at the average cash balance for the last quarter and not the closing amount
Time and place
One should never forget that the cash is valued on the last day of the financial period. Some companies deliberately inflate the cash balance by delaying supplier payments and chasing advance payments. In a perfect world, I would use the average cash balance for the last quarter and not the closing amount. I used to follow one UK company where the average net debt was about £1bn higher than the June and December snapshots.
There are other problems as well. Cash may be stashed in overseas countries that restrict capital transfers. Even if possible, repatriating the cash may trigger tax liabilities. The cash may be in countries with rampant inflation, so that the value in the reporting currency falls every week. In extreme cases, the auditor may have relied on a local accountant who turns out to be less than reliable. None of these problems is likely to be visible.
I am a big fan of using enterprise value-based metrics to value companies. I like the way this approach levels the playing field for companies with differing capital structures. But one should always look at the cash very carefully.
