Freedom Foods shows why it pays to check a firm’s cash-flow
Ignoring a firm’s operating cash-flow conversion for a period of time can be very risky. Particularly during a period of business stress, like we have right now. The most recent example of this is with Freedom Foods (ASX: FNP), which was recently put in a trading halt pending an investigation into its financial position – but not before its share price dived 14 per cent.
Last week, Freedom Foods disclosed to the market that long-time CEO Rory Macleod was on leave, while CFO Campbell Nicholas had resigned a day earlier. In conjunction with the announcement, the company disclosed an array of accounting-related issues including inventory write-downs of $35 million (in addition to $25 million disclosed in May, totalling $60 million or approximately 50 per cent of inventory) largely related to out of date stock as well as invoicing errors and additional bad and doubtful debt charges related to its Asian export strategy.
Going through the accounts, it is not immediately obvious there are questionable accounting practises in play. While checking conversion of EBITDA to operating cash-flow is a quick short-hand method to raise any potential flags, balance sheet moves must also be accounted for given changes to working capital. For a company growing revenue as quickly as Freedom Foods, working capital build can easily be explained by the need to build inventory ahead of anticipated sales growth.
In FNP’s case, the last 3 years (the period under scrutiny) does show a mixed picture in terms of operating cash generation, with two poor years in FY17 and FY19 partially offset by a strong 2018 cash number. However, further scrutiny of the accounts when adjusting for balance sheet moves does indicate some level of underlying weakness, especially when considered relative to changes in working capital ratios relative to sales.
Of course, these issues are “easier” to spot post the fact. Unfortunately, without significant expertise in accounting concepts, these issues are generally difficult to spot. It’s noteworthy that the majority of institutional investors had not picked up on some of these irregularities in the past (or brushed them aside), especially given the plausible explanation of Freedom Foods being a growth company.
A few things to consider when assessing operating earnings to cash flow:
- EBITDA to operating cash-flow – the simplest short-hand check on earnings quality. A 100 per cent conversion rate is unrealistic, but an average ratio consistently below 75 per cent may flag issues, especially for more mature businesses. In addition, a company with many years of significant “normalising” expense adjustments may warrant some caution as normalising adjustments may just be a cost of doing business.
- Adjust for changes to balance sheet items such as receivables, inventories and payables – as working capital changes can be significant, especially for retail companies. Changes to provisions are another area of potential focus.
- Examining a company’s financial history over a period of time – as only then will significant changes to a company’s balance sheet vs sales metrics that may warrant further scrutiny become evident.