In 2006, when private-equity group Blackstone put care-home provider Southern Cross back into public hands, the future looked bright. With an ageing population and a government keen to offload the burden of care onto the private sector, Southern Cross should have thrived. Yet fast forward five years and the company is being broken up, leaving investors nursing some painful losses.
What went wrong? Sometimes a firm runs aground with very little warning. But the sad truth is that, in this case, Southern Cross's accounts were riddled with warning signs that could have alerted observant investors to get out long before the company imploded. One problem is that, when it comes to analysing accounts, a profit and loss statement is as far as many investors ever get. As a snapshot of a year's trading, it's fine. But as a barometer of a firm's longer-term health, it's not. For that, you have to look at the balance sheet. This gives the cumulative net asset position and reveals a lot about what a business owns (its assets) and how it is all funded (liabilities and shareholders' funds). You don't need to be an expert to spot problems. Here are four.
1. Too much goodwill
At the top of a balance sheet you find a list of a firm's long-term (fixed) assets. Some can be kicked (tangible), such as property. Others, such as goodwill, can't. Goodwill arises when a firm buys other assets or companies. It is the difference between what a buyer pays and what they get back. As such it represents the subjective value placed on brands, market share and know-how. At Southern Cross the balance sheet had got out of kilter. Goodwill in the 2008 accounts was twice the value of total shareholder equity (£218m/£110m). The moment any of that goodwill became impaired' and had to be written off (highly likely with such an acquisitive firm), shareholders' funds stood to take a battering.
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2. Lack of liquidity
The current ratio compares the value of current assets (£95m in 2008) with the value of current liabilities (£197m). A ratio of 0.5 is already low for this type of business, where your main customer group local authorities is prone to late payment. Strip out properties held for resale (not the most liquid asset) and that drops to 0.3. Cash conversion rates (the extent to which operating profits were being turned into cash) were falling throughout the post-flotation period too. In short, in liquidity terms, this business was always operating on the edge.
3. Too much debt
In a bull market, when interest rates are low, debt financing can make sense, boosting returns to equity holders, in much the same way as buying a house with a small deposit and a big mortgage works when funding is cheap and prices are rising. But it's easy to get carried away and expand too fast on cheap money. By 2008, Southern Cross had racked up short and long-term liabilities of 3.7 times shareholder equity. Even if you strip this down to pure borrowings, the ratio is still around one for one. That wouldn't have been catastrophic had cash flow been under control. But it wasn't. Southern Cross was effectively in hock to its creditors for years. Worse, what was on the balance sheet was dwarfed by what lurked just off it.
4. The painful notes
Most investors can't bring themselves to read accounting notes. That's a mistake. As a rule of thumb, the further back a note is hidden, the more useful it is. In Southern Cross's accounts, note 34 detailed financial commitments totalling £6bn. The directors had committed the business to huge ongoing rental outgoings (with annual uplifts) under leases running for up to 30 years. Given the firm's income was uncertain (being dependent on both occupancy rates and the amount the local authorities were willing and able to pay), the business was highly sensitive to small changes in revenue (ie, it had high operational gearing). Under Blackstone, the income-to-rent-payable ratio was a healthy 1.8 times, leaving a decent margin for error. But as the business grew post-2006, this crept down to 1.5 then 1.1 (leaving no such margin).
The best of the rest
Those flags may seem technical. But even if you'd missed them, there were other clear warnings. For example, in the 2006 flotation, Blackstone effectively sold its stake in Southern Cross, deeming that a good point to get out. Then at the end of 2007, the firm's key directors dumped shares in the firm en masse. If those on the inside don't believe the story, it's not an encouraging sign.
Also, the firm was far too reliant on one customer. The government supplied around 80% of its revenues. You can't assume any client not even the government is a bottomless pit. And this applies to more than just customers: if a company depends too much on a single supplier, or patented product, or a set of regulations, that's always a red flag. Then there was director turnover. If someone at the top leaves, it's either because they've been poached or dumped. The departure of the finance director in 2008 and the chief executive not long after were more warning signs. Put it this way, and it's a miracle investors stayed around as long as they did.
See Tim Bennett's video on Ten Red Flags Southern Cross Missed.
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