Numbers can be fudged, cash not

Reading the Rolfes restated results, I was struck by how easy it is to fudge numbers and how hard it is to fudge cash. Rolfes’ financial director left early this year when it was discovered that he was seemingly not doing things by the book. News of this sent the stock down some 20%.

The recently released results had to restate previous results to correct for the errors, and while there were lots of moving parts and great disclosure from the company, the cash was largely unchanged – because cash is cash.

Now, before moving on, the fact that Rolfes’ former financial director, Johan Ferreira, was seemingly able to cheat the numbers raises two important questions. Where was the board, which should have had more oversight? And perhaps even more importantly, where were the auditors who, at the time, were SizweNtsalubaGobodo?

Both the board and auditor are supposed to ensure that the information presented to shareholders is correct. Sure, no process is foolproof, but this failure is an indictment on both.

The board has been strengthened in the last few months and the new acting chief financial officer (CFO) is Richard Buttle, the previous CFO at Metrofile*. The new auditors are KPMG!

Let’s move on to the cash. The overstatements within the Rolfes results were all about profits, because those numbers can be fudged. Write-downs can be adjusted, depreciation can be changed, valuations can be hiked and revenue or costs both adjusted. But cash is cash and either it is sitting in a bank account or it is not.

With Rolfes, and with hindsight, one of the concerns had always been that cash conversion ratios were low. Sure, the company made profits but cash was always a bit weak. We now know that this is because the profits were fake while the cash was not.

So, while fraud is hard to detect for an outside shareholder, there are some things we can keep an eye on to get an idea not just of whether fraud is being committed, but also of the quality of the business. The first is how much of the profit reported actually ends up as free cash in the bank – cash conversion.

I am not talking about net cash – which is cash less debt – nor near cash, which can be almost anything. I check the cash flow statement and see where it went and how much extra cash ended up in the bank account compared to profits.

I also check dividends as this is the purest form of cash for a shareholder (as it ends up in our hands). Warren Buffett once quipped that the only two numbers you can believe in a set of results are the page number and the dividend.

However, the dividend is more than just what we receive. It is also the company policy. How much of headline earnings per share (HEPS) does it pay out as a dividend, the cover ratio?

The actual number is less important. What is important is rather if it is adhered to and if the trend is towards paying out more rather than less profits as a dividend.

Now sure, sometimes a large deal may scupper this policy as we saw recently with Famous Brands’* UK acquisition, which resulted in the company cancelling the dividend to pay off debt quicker. But this was fully explained and makes sense.

Watch the dividend and watch it in relation to HEPS growth. I remember African Bank’s HEPS increasing in the years before the bank imploded, while the dividend did not follow suit. This was the first sign of trouble for the bank.

As I always say: we want revenue growth with HEPS growing faster and the dividend even faster. If not, ask why this is not happening.

*The writer owns shares in Metrofile and Famous Brands.

This article originally appeared in the 19 October edition of finweek. Buy and download the magazine here.