How 'bad profits' can poison your investments

published 6 August 2010

It seems I stirred up a bit of a hornets' nest recently. So what exactly caused this reaction...?

Well, I said that you shouldn't trust goodwill on company balance sheets like Connaught's. That's because goodwill is an asset that can't be sold and you can't use it as collateral if you suddenly need to borrow some cash.

And boy did it stir up readers to make another very important point... make sure you know where the profits are coming from.

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Let me explain the idea of bad profits' and how not to be fooled into a terrible investment.

Can a profit ever be bad?

I must have read a hundred books on investment and finance by now; each of them usefully useless. There are usually some good ideas, but ultimately they repeat the same blindingly obvious thing in a hundred different ways.

Invest in companies with growing profits

Simple, right? Wrong.

Unfortunately, investment has a way of throwing a spanner in the works of even the most simple idea. You see, there are different ways to grow profits, and some of them lead to 'bad profits'.

Connaught took over plenty of businesses and then used cost cutting to squeeze profits out of them. It hardly takes entrepreneurial brilliance to act like the playground bully. Sure, this model works for some. Philip Green, the 'fashion store magnate' is reputedly ruthless to suppliers and landlords alike.

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All I'm saying is watch out. Any business that treats people shoddily to improve profit runs the risk of losing staff and suppliers. It's usually not a sustainable business model.

But wait a minute, I hear you say. How can you possibly tell if a company's shafting its suppliers and staff? Good question. And here are a couple of things to look out for.

The real meaning of creditor days and how it can help you dodge losses

You can get an idea if companies are squeezing suppliers by looking at an accounting ratio called Creditor Days', the time it takes to pay suppliers.

But beware, the text books will mostly tell you that the more creditor days' (i.e. the longer it takes a firm to pay) the better... But don't believe them.

To me it says that either they've got very little money, or they don't care about suppliers. Either way, higher creditor days is the first warning sign.

The second thing to look out for is increasing profits without increasing turnover. This means that profits are coming from cost cutting.

And growing profits through constant cost cutting isn't sustainable. At some point you run out of costs to slash. Of course, they can then buy up a competitor and slash costs again. Fine, but at some point they run out of acquisition targets. And remember, they've still got to pay for these acquisitions. At the same time, the business can be rotting from within. If they can't motivate staff, suppliers and sub-contractors then they'll walk.

On the other hand, a decent business will naturally increase turnover (known as organic growth). If you offer great services and products, customers come to you...

Simple.

This article was first published in the free investment email TheRightSide

Your capital is at risk when you invest in shares - you can lose some or all of your money, so never risk more than you can afford to lose. Always seek personal advice if you are unsure about the suitability of any investment. Past performance and forecasts are not reliable indicators of future results. Commissions, fees and other charges can reduce returns from investments. Profits from share dealing are a form of income and subject to taxation. Tax treatment depends on individual circumstances and may be subject to change in the future. Please note that there will be no follow up to recommendations in The Right Side.

Managing Editor: Theo Casey. The Right Side is issued by MoneyWeek Ltd. MoneyWeek Ltd is authorised and regulated by the Financial Services Authority. FSA No 509798. https://www.fsa.gov.uk/register/home.do

Bengt graduated from Reading University in 1994 and followed up with a master's degree in business economics.

He started stock market investing at the age of 13, and this eventually led to a job in the City of London in 1995. He started on a bond desk at Cantor Fitzgerald and ended up running a desk at stockbroker's Cazenove.

Bengt left the City in 2000 to start up his own import and beauty products business which he still runs today.