Financial drugs in business
With the news channels full of drug abuse in sport, let’s consider drugs in business. Are there performance enhancing substances that flatter company performance? And are they addictive? There are, and here are two examples:
1. Debt
Debt is a performance-enhancing drug that can be both addictive and deadly. But it’s more like alcohol than heroin: it has social respectability and is normally safe within reasonable limits.
Financing a company with debt is cheaper than equity (it’s lower risk for an investor and interest is tax-deductible). Highly leveraged companies have a lower WACC, so increasing leverage for a company generates higher shareholder returns.
If the business is growing and generating more profits, it can have a greater debt capacity, providing greater opportunity for dividends or capital returns to shareholders.
So, especially for a profitable growing business, debt can be a good thing, rather like a glass or two of good wine. Private Equity returns, flattered by very high use of debt, have outperformed public market returns in recent times and are perhaps at the magnum-of-champagne end of financial drug taking.
The dark side of debt is that it doesn’t go away if the company falls on hard times. Interest payments still need to be made, the principal must be repaid on time and loan covenants need to be complied with. If the company fails to meet its targets, shareholders are disappointed, but loan providers end up with the keys to the company.
In the global financial crisis that started with the debt-fuelled, who-cares-about-equity sub-prime crisis, we were all, young and old, rich and poor, individual, company and country drinking too many magnums of debt champagne and the hangover is still being felt by many.
Consommez avec moderation is good advice, for both alcohol and debt.
2. Aggressive accounting
CEO to accountant: “How much profit did we make?”
Accountant to CEO: “How much do you want to make?
There are two main objectives of creative accounting: to show the company is growing faster than it in fact is, or to pretend the company is more profitable than it is. There may be different motivations, but often it comes down to CEO hubris and a desire to achieve targets and bonuses. The basic techniques are to bring forward revenue, and defer or capitalise expenses.
Revenue is brought forward by aggressive recognition policies, where the sale is recorded either before it’s definitive or earlier than the commercial reality. Over-stocking resellers may not sound bad, but offering an incentive to a reseller to take product they do not need and will return in the future for a full refund certainly is. Tesco’s recent accounting scandal for example involved recognising revenue from supplier incentives that were tied to sales goals before it knew the targets would be met; Quindell, a British company that could have won a gold medal at the Creative Accounting Olympics, recognised the estimated value of legal claims before they were even won, let alone settled.
Costs are best deferred by capitalising them. Software companies, for example, may capitalise software development costs and amortise them across the estimated life of the software. This is not sensible, especially for an early stage company that hasn’t much evidence about pricing, business models and market size. FASB, the American organisation responsible for accounting standards, allows software capitalisation but few sensible software companies do so.
Talking of Olympics, you could make a profit from those famously financially onerous games by recognising ticket revenue when the tickets are sold rather than at the time of the event; capitalising personnel costs as part of the infrastructure investment and creating an intangible asset called Goodwill or similar, representing the difference between the cost and the net realisable value of the infrastructure. Bingo, even the Athens games are now profitable. Only problem is, the state still goes bust.
Regulators tighten rules and guidelines regularly, but creativity in accounting persists. And these are hard core drugs, the financial equivalent of injecting pure heroin into eyeballs. Dependency follows; death is likely.
