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Firms attempt balancing act

By Peter V O'Brien

Friday 21st February 2003

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Moves to improve balance sheet ratios and operating cashflows were apparent in the previous reporting round.

Many more reports will be issued in the period to the NZSE cutoff date for December-balancing companies but they should confirm the trend shown in the table.

The appropriate balance between debt and equity (leading eventually to an equity/total assets ratio) depends in part on the company's activities.

Financial institutions ­ banks, for example ­ have low equity/total assets ratios, because borrowings and loans are massive and gross income less gross expenses leaves the companies with substantial earnings before tax (interest having been accounted for in expenses), which are sufficient to support the equity structure.

Non-financial companies should constantly assess their financial structures.

The process includes consideration of whether they are overcapitalised or undercapitalised, interest rates, the debt/equity ratio, stock turn (related to sales revenue and operational cashflows) and the net operational cashflow itself.

Most listed companies in New Zealand are realistically capitalised but there are still cases where directors and executives pride themselves on nil debt and consequent proprietorship ratios in the 90% plus region. That is an inefficient use of corporate resources.

The adage "neither a borrower nor lender be" could have relevance to maintaining personal financial stability but it is unrealistic for companies when related to tax regimes, financing shareholders' expected returns and a possible lack of investment outlets for the "excess" capital.

Cashflow is inextricably woven into those issues but it is remarkable how many companies and the people who analyse them fail to discuss actual or potential operational cashflows. The matter was considered in The National Business Review, August 16, 2002.

Profit and cashflow are not the same. It is possible for a company to have a "profit" but lack the cashflow to finance ongoing operations.

That comment is subject to the point that cashflow in a given period is no more than cash received and paid.

It is the reason that astute investors (and astute analysts as well) should examine balance sheets carefully to see how a rise in receivables, for example, could improve operational cashflows in the next accounting period, assuming debtors paid outstandings.

Assessing debtor quality in industrial, non-finance companies can be a hit-or-miss business. There is a widespread assumption that balance-date debtors will fix their accounts, unless they have a bad credit record, and an equally widespread desire for creditors to present accounts in the best possible way.

It could be argued auditors have a say in that scenario but they have to question directors and executives. They also have to accept judgments, as opposed to actual disclosures in the books, when issuing reports.

The question of sound debtors, again related to cashflow and balance-sheet receivables, has particular relevance to companies supplying goods to people involved in contracting or subcontracting to the property development sector. If a developer or main contractor goes down, there are flowons to subcontractors and back up to the main supplier.

That is hardly theoretical. It has happened often recently, when developer main contractors suffered bank or other lender closedowns.

Listed company suppliers presumably have their antennae flicking around the commercial community but some reports often take a shock reaction to customer failures.

Such comments should be another warning to investors who look at financial ratios, cashflows and receivables.

Suppliers would be responsible for checking the deals developers do with contractors and those the latter do with subcontractors if the suppliers are listed companies.

Nothing is gained if debtors at balance-date are taken to revenue on accrual accounting principles if the accruals have to be reversed later. Cashflow would fall, as would equity, adjusted profit and, presumably, the share price.

There is more to a company's financial health than assumed profit projections.

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