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The movement of money in a company can reveal a story that other statistics would hide from investors until they have had their fingers burned. Peter Webb hunts down the clues and seeks foresight, not hindsight

Last week we looked at Centurion Electronics (CUC:AIM) and the disparity reported between profit and cashflow. A look at the cashflow statement showed that while it reported an operating profit of £2.5 million, the company actually lost £1.2 million in cash from operating activities. While it is not unusual for a fast-growing company to experience cash outflows, my concern was that things were not going in the right direction.

Looking at the company on the qualitative side, it also painted an unappealing picture. Lack of pricing power and competitive advantage were my main concerns. Centurion’s products appeared to be easy to replicate and there were low barriers to entry in the market. Most of Centurion’s customers were large companies with the benefit of a large number of competing suppliers that also possessed significant bargaining power.

Centurion had done pretty well to date though and powered ahead under an influential CEO. It was a shock to all when he died in a car crash, and his influence over such a small company was also a concern. The late CEO seemed to hold a lot of equity with customers, and without him these relationships were probably diluted. This merely dulled any lustre the company once had. From a qualitative viewpoint there were concerns even if they were directly unquantifiable.

Early warning

The trigger for analysis, though, was the cashflow. As well as cashflow there are extra ratios that can be useful in assessing the quality of stock, debtors and creditors, the main causes of Centurion’s outflow. Stock turns will tell you how often goods are being moved through the business, high turns mean the process from assembling goods, to delivering them to customers is efficient. Low turns means that goods are not moving fast. Creditor and debtor days will allow you to see the average credit terms the company is giving to its customers and those it is receiving from its suppliers. Ideally, these should be in balance and in the case of retailers they are usually very favourable as they buy on credit and sell for cash. If debtor days are higher than creditor days this is a significant drain on cash. Long and increasing debtor days can be seen as a sign of trouble.

Bad signs

You can see from the illustration how these ratios have been calculated and their impact. When these ratios worsen there is generally considered to be a deterioration taking place within the business. A low stock turnover figure implies poor sales and, therefore, excess inventory. Lots of inventory represents a poor use of cash, it also opens the company up to trouble if the product is prone to price deflation. For a business whose product deflates in value very quickly, the figure for Centurion seemed a remarkably low amount representing either too much stock or failure to turn it fast enough. When I worked with similar products in a former life, buyers were often punished for not turning stock 12 times a year!

The debtors figure didn’t look amazing either. By maintaining accounts receivable, firms are effectively extending interest-free loans to their customers, which has to be funded by the company some how. A low ratio implies that the company is possibly extending generous terms or delaying collection. Large companies’ terms of trade can be pretty demanding. In order to get a listing with a large customer where you are selling ‘me-too’ products, you very often need to give generous terms. These could include offering sale or return, extended payment periods or maybe offering to fund promotions. If the product is not selling, you can often be forced to reduce to the price, extend payment terms or in the worst case accept stock back.

While these calculations are useful indicators they are not foolproof or necessarily indicative of issues; therefore you should treat them with caution. However, they can provide you with absolutely vital clues as to what is going on in a company. With these clues, not only are you armed with information, you are armed with key questions.

Not content with collecting information, I decided to contact Centurion with those questions. When contacting the company, I was unable to get the answers I was looking for and the general lack of a positive response was another concern to add to the list.

Cashflow turned my warning antennae to amber and that amber was now turning a distinct shade of red. Shortly afterwards the finance director resigned. Given all the evidence, a profit warning seemed inevitable. Sure enough, two profit warnings followed in quick succession with the announcement that Centurion was going to have to write off up to £2.4 million worth of stock.

Shareholder equity was reduced by 35%, the share price fell 70% and management credibility was significantly pummelled. Several restructurings later, things are still distinctly uncertain and shareholders have pretty much lost their entire investment.

As you can see from my analysis, profit warnings generally don’t occur out of the blue. Follow the clues and you can benefit from foresight, rather than hindsight.