The lessons to be learned from Polly Peck

Former tycoon and Polly Peck chief executive Asil Nadir wasrecently sentenced for stealing nearly £29m from the company he set up and listed.

I'd like to look at the story from an investment angle. Beyond the lurid headlines, it's useful to understand that Polly Peck's financial troubles were not just caused by fraud and theft. They were also rooted in a very simple accounting trick that investors at the time should have spotted and it's something we can all still learn from today.

Nadir wanted to create a high level of income in the profit-and-loss account of his company, so that the reported profits went up year on year. So without getting into all the gory details, here is the nub of what Polly Peck did: one of the group's largest overseas companies borrowed in sterling a developed world currency then invested in a far weaker emerging market one, with no hedging in place.

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Why do this? Developed world currencies usually pay lower interest rates than emerging ones (where a central bank has to fight harder to attract investors). Say you borrow £10m at 5% interest. You immediately switch this into, say, Turkish lira, which you invest locally to earn a return of, say, 20%. The gap between those two rates means that, at least for a while, you are making a nice high net return you are earning 20% while only paying 5%. That difference between income received and interest paid will make your income statement overall look healthy, even if the lira weakens a bit.

However, the weaker currency will come back to bite you. Let's say, purely for illustration, that when the £10m is switched into lira the exchange rate is one for one so £10m becomes ten million lira. However, over the next few years the lira slides against the pound to a rate of two to one. Now when you convert ten million lira back into pounds they are only worth £5m, not £10m. So gains on any interest rate differential are now being lost in capital losses on your lira investment.

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The accounting trick that fooled Polly Peck's investors

Asil Nadir brought Polly Peck to its knees using a simple accounting trick that could still work today. Tim Bennett explains how you can avoid being caught out.

Watch all of Tim's videos here

But here's the trick Nadir exploited under the accounting rules for overseas subsidiaries, any capital losses on investments funded using a sterling loan went through Polly Peck plc's British balance sheet (into a place called reserves') instead of the latest profit-and-loss account. In short, they were hidden from any less-than-alert investors.

The upshot? Polly Peck's profit-and-loss account showed healthy investment income for years, and few investors asked how this could be. The answer was that the firm was also suffering big foreign exchange losses on its investments, which were being swept under the carpet by being dumped in the firm's balance sheet. Polly Peck reported strong profits alongside a shrinking balance sheet for years before it finally collapsed.

The lesson to learn here is that, as the ex-head of the International Accounting Standards board Sir David Tweedie once noted, the balance sheet is the most important statement a firm produces. If you are not sure how it works, look at my short video guide. Meanwhile, here are three more balance-sheet warning signs to watch out for.

1. High intangible assets

Rather than grow your business the hard way (organically), you can buy other businesses. This makes for more rapid expansion, and also generates fees for investment banks, which is why they always encourage boards to empire-build. It comes with another bonus too big mistakes can be hidden away. The trick is this you pay, say, £100m for a business with assets worth just £50m. The difference is called "goodwill" in this case, £50m. It represents the intangible value of the target firm's brand, market share and so on. The £50m sits on the balance sheet of the acquiring company. If it later turns out that the acquirer paid too much, this £50m is "impaired", which simply means, "reduced in value". This hit which sometimes amounts to the entire value of the goodwill usually ends up in the profit-and-loss account, but typically the directors will encourage you to ignore it as a one-off' cost.

2. Rapidly increasing current assets

A firm's short-term balance-sheet assets are called "current". These are assets needed to run a business, such as cash, stock for resale, and amounts owed by customers. Usually these move in line with sales. If a business boosts sales by 10% in its profit-and-loss account, with the same terms of trade with its customers and suppliers, stock and receivable balances should move up by around 10% too. When you get a big unexplained jump in stock for resale or receivables with no corresponding change in sales, watch out. It suggests the firm is either struggling to shift stock or not managing customer collections properly. For more on this, have a look at my video Why Do Profitable Firms Go Bust?

3. A shrinking balance sheet

As the Polly Peck collapse showed, a combination of rising profits and a shrinking balance sheet is a disaster waiting to happen. So the third, but perhaps most important, test is this take a look at the net assets total in the balance sheet. This sums up all a firm's assets, both long and short term (what it owns and is owed by other people) and deducts all liabilities (what it owes other people, whether trade suppliers, banks or whoever) to give a net position. In effect this is a snapshot of the firm's overall wealth. If this number is getting smaller over time, be concerned. A successful firm should not only show rising profits each year, but it should also have a bigger and bigger balance sheet. Otherwise it is all mouth and no trousers.