Net debt is a vital metric for investors and lenders. What ultimately kills companies is when they are unable to pay their debts when due. Hence, measuring the ratio of net debt to profits (and cashflow) is crucial to judging a company’s ability to pay and whether it is likely to find itself in trouble, potentially leading to a permanent loss of capital for investors.
Therefore it is very troubling that there have been several instances in recent years where reported net debt has proven to be misstated. As an investor in Redcentric (RCN) that is the situation I am most familiar with. Patisserie Valerie (CAKE) is another example. Kier’s (KIE) recent rights issue and share price collapse is another example of a firm running into debt trouble.
It is Kier’s statement that has, somewhat belatedly, led me to write this article.
The trouble with “net debt”, as reported as a single figure in firms’ interim and annual statements is that it is snapshot at the balance sheet date. Now, by delaying payments to suppliers or incentivising customers to pay promptly, it is easy to massage this snapshot. So the quoted net debt may not be representative of the true situation. Kier’s statement makes this clear:
The Company reported net debt as at 30 June 2018 of £185.7 million. The Group also reported average month-end net debt for the year ended 30 June 2018 of £375 million and calculated its average daily net debt for the year to be approximately £90 million higher.
In the case of Redcentric and Patisserie Valerie, the “massaging” went beyond the bounds of acceptability, leading to a need to restate the companies’ accounts. That, in turn, led to substantial share price falls and losses for investors.
It seems to me that there is a simple solution to this loophole: require financial reports not just to show net debt at the balance sheet date, but also the average daily net debt and the maximum net debt level in the reporting period. Those figures would be much more difficult to massage than just the period end net debt and more meaningful.
I suggest that the ShareSoc/UKSA policy team puts this proposal forward to the FRC, for incorporation into future reporting standards.
In the meantime, shareholders may be able to detect higher average debt levels than that stated at the balance sheet date by comparing finance charges disclosed in P&L statements with the stated debt levels and interest rates that the company discloses that it pays.
Excellent comment Mark, useful for analysis not only for seasonal businesses but also businesses massaging figures – Lehman and Enron come to mind as well.