The deadly accounting trap that can destroy your investments

By Bengt Saelensminde Jul 27, 2010

Bengt Saelensminde

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Oh dear, oh dear, oh dear. The financial engineers have been at it again. And this week, a British company that had been worth over half a billion pounds lies in tatters.

Of course we’ve seen it all before. But wary investors avoided this disaster stock. Why? Because they knew all about the weird and wonderful accounting principle that helped bring it down.

And that is ‘goodwill’ - a strange name for such a dangerous idea.

Stock market darling gets taken out

Earlier this week, Connaught group lost 80% of its market value, falling from around a pound to 20p. Worse, the price was around £4 at the end of last year. That’s a 95% loss!

Now on paper this company looks like a good business. It maintains social housing, public areas, street cleaning and things like that. And it’s got £2.6bn in forward orders. Seemingly secure contracts from solid payers - what could be better?

But the problem is, like so many businesses, Connaught took a short cut to the top. The quickest way to grow a business is to buy up competitors and integrate them. Hey presto! You’ve got a massive business and management can earn massive salaries.

Just look at Connaught’s chart over the last four years. It was barely affected by the financial crisis... I’d call that a stock market darling.

 Click here to enlarge

But there’s a potential problem when you ‘buy in’ growth by acquisition. Let’s see how it brought down this company.

Competitors won’t sell their businesses for ‘book value’ - that is, the value of its assets (unless it’s a loss-making business). So for instance, if you’re buying a park maintenance contractor that’s got £5m in assets (buildings, vans, mowers etc), you may have to pay £20m, because of its loyal staff, its good reputation, etc. These are the things you can’t really put a value on, but are what makes the business tick.

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This extra £15m you’ve paid goes onto the balance sheet as ‘goodwill’. But there’s a problem here - there are no assets to back up that £15m. There’s nothing to sell and there’s nothing to borrow against if you run into cash-flow problems.

So you’d better make sure you can afford your acquisition.

A potential double whammy...

If you’ve got a great business, with a strong balance sheet, you may not need to borrow any money. You’ve got nothing to worry about from the goodwill on the balance sheet.

But if you borrowed a load of money to acquire businesses in the first place (like Connaught did), then you’ve got a potential double whammy. You’ve already got high debt and you’ve not got much chance of borrowing more for any ‘unforeseen’ circumstances.

And this is what investors MUST, MUST be alert to. Don’t assume that assets on the balance sheet are ‘real’ tangible assets. If a business has goodwill, you need to beware.

Here’s how many investors missed it. You could be forgiven for thinking that Connaught’s balance sheet was okay. At a glance, it had £508m in assets and £315m in debts (as at the end of February this year). I wouldn’t normally be happy with so much debt, but then again, with long term contracts in a stable industry, why not?

But looking a little closer, you see that about £220m of the company’s so-called assets are goodwill. Oops. That doesn’t leave much leeway if something goes wrong. It’s got more debt than it has ‘real tangible’ assets!

And then something goes wrong...

As we all know by now, this government wants to reduce public sector spending. And that’s already hitting Connaught. Delays in projects have impacted cash flow and there’s great uncertainty over new contracts. Basically, there’s less cash coming in and likely less in the future too.

But the bad news doesn’t end there. Connaught employs sub-contractors and suppliers, all of whom get nervous if there’s a sniff of financial weakness in a client. Any decent supplier or sub-contractor will keep a close eye on his customer’s financial position.

They won’t supply, or work for anyone that may end up bust. Or, if they do, they’ll be asking for cash up front. That’s cash that Connaught just hasn’t got!

Suddenly a bad situation gets a whole lot worse.

That’s why you can’t trust anything management says

Just three weeks ago in its Interim Management Statement (IMS), Connaught told shareholders that revenues were robust, it had a good pipeline of business, the business was performing well and the outlook for the group ‘remains robust’.

Well what else could they say? Any sign of weakness would bring on a crisis of faith.

Then this week they said they urgently need funds to remain in business!

Connaught won’t be the first victim of Downing Street’s swingeing budget cuts. But these cuts needn’t bring a business to its knees as it did here.

Don’t think a company is safe just because it’s got assets to balance debt. Remember, goodwill is not a normal asset. It can be written off at the stroke of a pen and banks won’t lend against it if the business is in trouble.

• This article was first published in the free investment email The Right Side

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Comments (8)

Published in Tips & advice | More articles by Bengt Saelensminde

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  • 1. Jon

    (28 July 2010, 10:13AM)  Complain about this comment

    Surely this 'goodwill' was in the accounts all along, and so investors and analysts either were ignorant or turned a blind eye. Either way, tough luck - as you suggest, do the basic maths of real assets vs valuation.

    How many other companies are in similar positions, which companies are they, and why are they not being rooted out by analysts ?

  • 2. cider monkey

    (28 July 2010, 02:25PM)  Complain about this comment

    2.s I agree totally with what you are saying, large companies like this should be named and shamed, their size should be no defence. The UK government should bring out a law stating all invoices to be paid within 35 days (5 weeks) or implement a 5% service charge. If the government wants to encourage small business it needs to protect them

  • 3. Colin Hardy

    (28 July 2010, 03:56PM)  Complain about this comment

    The Financial Services Authority exclude Goodwill as an asset when
    assessing the required level of financial resources of a Regulated Firm.
    This rule is an important protection to consumers & suppliers.

  • 4. Tiny Tim

    (28 July 2010, 08:14PM)  Complain about this comment

    I have always thought that goodwill should be written off to the profit and loss immediately a company is purchased as there is no way of putting a true value on it. You can't insure it like other assets therefore it has no true worth. This would then see some of the silly takeover valuations reduced and purchase prices would be based on real company earnings and the value you can extract via economies of scale, vertical integration etc.

  • 5. Jeff

    (28 July 2010, 08:41PM)  Complain about this comment

    I figure goodwill is only worth anything if it allows the company to charge more for the product & typically make higher profits. ie like a really good brand name.

    Also, it' quite easy to look at net assets & then subtract intangibles to get a "net tangible assets" figure, which can be compared with market capitalisation..

  • 6. Gary

    (28 July 2010, 09:43PM)  Complain about this comment

    Totally agree with cider monkey with regards to regulations around payment of debt within a set period. However, a subcontractor, maybe more so than a supplier, becomes trapped and therefore its position weaker by the level of debt incurred when faced with the known industry 'tactics' of these type of companys. Connaughts poor payment of suppliers etc is nothing new, however such is the large slice of cake of the sector they have, suppliers probably foolishly chased the work rather than the payment or indeed profit. All such companies should also be capped to prevent having too much of the sector thus spreading work around more any, not having all eggs in one basket, which I suspect many are with Connaughts. The fall out could be enormous throughout the industry.

  • 7. Tyke 59

    (29 July 2010, 01:04PM)  Complain about this comment

    The business review currently being carried out by Deloittes will be critical in determining continuing medium/long term bank support for Connaught. Expect some severe criticism of Connaughts accounting practices, management structure/quality and internal controls. Goodwill cannot now be justified in the balance sheet and will therefore result in a £200m write down (at least this is a non-cash item). It has been apparent to some of us in the industry for some time that Connaught's rapid growth combined with their contract performance had led to financial problems. I do not understand why most of Connaught's "blue chip" clients did not carry out a financial review of the company before committing to long term contracts. It should have been apparent that trouble was brewing-far better to spread the work between reputable, long established, financially sound regional providers.

  • 8. P1 Enterprise Solutions

    (02 August 2010, 01:12PM)  Complain about this comment

    I must disagree with the writer of this article in his total disregard of some key observations and a blatent attempt to blame simplistic accounting prinicples for major stock market movements.

    Connaughts is a business with significant secured future work, public sector customers (who generally do not fall back on payments), and a suply chain that Connaughts can dictate payment terms. This should provide security to plan and operate your business and a resultant positive cash balance. This is why investors valued it at the level they did. Not just on a Net Asset position.

    When Connaughts issue a profits warning and a requirement for further lending, the market obviously realise there are some much more fundamental issues within the business than just a treatment of accounting policy.

    There may well have been some questionable accounting practices within the business in its recognition of profit (especially in long term contracts), but the writer has ignored this.

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