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However, Versailles' business differs significantly from traditional trade factoring. Versailles describe traditional finance schemes as having "always meant restrictions, tying businesses down with minimum notice periods, fees and charges over personal assets. Not to mention debentures and guarantees."
Yes. Anyone who has read the The Motley Fool UK Investment Workbook and then read any one of the last four Versailles annual reports should have kept well away.
All looks in reasonable order here. (However, it is worth comparing the net interest payable to the operating profit of each year. Note that for 1999, 20% plus of operating profits become subsequently absorbed into interest payments. Obviously Versailles is a company whose profits are very sensitive to any interest rate changes. This is important for later.)
If you've read The Motley Fool UK Investment Workbook, then you'll know that better companies generate "cash" profits, as opposed to just "accounting" profits. (You do own a copy of the book, don't you?) So what does it say in the book about this profit into cash conversion? Let me remind you.
For 1999, the cash conversion ratio was (£15m)/£15m giving -100%. In fact Versailles had negative conversion ratios for the last four years! These figures are miles below The Motley Fool's 80% rule of thumb!
Possibly. Again, it must be stressed that there has been no definite confirmation of any irregularities at this point, only that an investigation is under way at Versailles. But it does no harm to look. Of course, when you are specifically searching for potential accounting irregularities, spotting any "concerns" does become that much easier.
One thing does spring to mind here. All the calculations are high compared to commercial borrowing rates of, say, 7%, seen over the last four years. Obviously there is room for error here in the admittedly rough calculations, but the figures do appear odd when considering the importance of debt to Versailles' overall business.
It's simple to write about avoiding Versailles in retrospect. Against a meteoric share price rise fuelled partly by media recommendations, it must have been difficult for an investor to focus on any cash flow concerns before the suspension. Even a tie up with the Royal Bank of Scotland (LSE: RBS) appeared to legitimise the whole Versailles operation.
Since the listing suspension last Wednesday, the story has got rather murkier. Gloomy details have emerged over the weekend, including the DTI raising concerns with Versailles over accounting standards back in August. All the latest revelations have put a rather dark cloud over a Versailles share placing and director dealings in November.
It must be stressed that there has been no definite confirmation of any irregularities at this point, only that an investigation is under way. Versailles are due to report on the conclusions from the investigation by 31st January 2000. But from reading the press lately, things do appear grim for shareholders.
So the questions Versailles shareholders are probably asking themselves now are 1) could I have avoided Versailles in the first place? and 2) could there be any accounting irregularities? I'll try to answer these later. Firstly, some background on Versailles itself, best explained by an example.
Company A has won a big order from Customer B to produce 1m widgets. Customer B's terms are that payment to Company A will be made 90 days after receiving the widgets. Cash flow constraints mean Company A can't wait that long, and needs the cash as soon as possible. So rather than wait three months, Company A can instead go to a "trade financing" company. Enter Versailles.
Versailles were kind enough to outline the steps involved in this type of transaction in their 1998 annual report.
Versailles' "unique" approach is based on financing individual transactions. Where as a typical bank or factor would consider the strength of the balance sheet of those involved in the transactions, Versailles would effectively base the transaction on its own individual merits. Versailles don't exactly explain in any annual report how they do this, but it's described as an "innovative, flexible approach to trade finance that has given a whole new meaning to the phrase 'cash flow solutions'."
I'm not entirely sure of the nitty-gritty involved in Versailles' operation, but you may care to read this post from anquetil and this from colinalexander for further enlightenment. Is it a case of beware the company whose operations cannot easily be explained?
On to those shareholder questions.
Could I have avoided Versailles in the first place?
A quick look at the Versailles five year "accounting" profit record first.
Twelve months to 28th February
1995 1996 1997 1998 1999
(£000) (£000) (£000) (£000) (£000)
Sales 46,604 72,654 103,672 155,642 232,424
Operating
Profit 2,825 4,433 6,508 9,901 15,373
Net Interest
Payable (719) (1,222) (1,386) (2,202) (3,949)
Profit before
Tax 2,106 3,211 5,122 7,699 11,424
Profit after
Tax 1,393 2,135 3,420 5,184 7,892
Earnings per
Share 0.69p 0.94p 1.37p 2.05p 3.12p
But moving on to working capital cash movements, dark shadows begin to appear...
The reconciliation between operating profits and net cash inflow from operating activities for Versailles since 1995, then:
Twelve months to 28th February
1995 1996 1997 1998 1999
(£000) (£000) (£000) (£000) (£000)
Operating
Profit 2,825 4,433 6,508 9,901 15,373
Increase in
debtors (3,458) (9,616) (9,305) (16,921) (32,779)
Increase in
creditors 632 1,923 2,016 2,120 2,095
Other 19 29 55 84 189
Net Cash inflow
from operating
activities 18 (3,231) (726) (4,816) (15,122)
"Companies that consistently have a cash conversion ratio of less than 80% should be treated with caution". The ratio is calculated thus:
Net Cash inflow from operating activities
-----------------------------------------
Operating Profit
There's no need for an investor to try and figure out how and why cash was evaporating, and whether this was normal practice for a business such as Versailles. At the end of the day, there was absolutely no cash coming through underpinning reported profits. And that is all you needed to know about the Versailles financials to arrive at the investment decision of "No".
Forget about the historic sales and earnings record and the predictions of more substantial growth in the pipeline. Alarm bells from the cash flow situation should have been deafening. "Turnover is vanity, profit is sanity and cash is reality" as someone once said.
Could there be any accounting irregularities?
Remember from the accounting profit table how sensitive Versailles appeared to be to interest rates? With that in mind, it's an interesting exercise to calculate the "effective" interest rates that Versailles had been paying on its debt. For this rough calculation, I've divided the net interest payable figure by the average net debt employed throughout the year.
Twelve months to 28th February
1995 1996 1997 1998 1999
(£000) (£000) (£000) (£000) (£000)
Net interest
payable (719) (1,222) (1,386) (2,202) (3,949)
Year end
net debt (6,987) (10,420) (13,961) (23,166) (46,048)
Average
net debt (8,704) (12,191) (18,564) (34,607)
Effective
interest rate 14.0% 11.4% 11.8% 11.4%
Interestingly, Versailles also stated that a preliminary indication of the accounts may not have complied with Financial Reporting Standard 5 (FRS5). This now causes a lot of speculation on my part.
FRS5, by and large, tackles the thorny subject of "off balance sheet" financing. In the pre-FRS5 days, companies had found complex ways of essentially holding liabilities that were legally not required to be reported on the group balance sheet. FRS5 put an end to such shenanigans. So with the mention of FRS5 by Versailles, could there be additional debt lurking that had not been reported in the accounts? Are the high effective interest rates a sign of missing balance sheet debt? That is, if any alleged additional debt were brought into the prior calculations, then the effective interest rate would look far more realistic. I emphasise that this is all speculation on my part, of course.
And Finally...
In summary, I think the points to remember from the Versailles episode are 1) make sure you have read The Motley Fool UK Investment Workbook; 2) always look at the cash flow conversion ratios of a company; 3) when it comes to cash, it's always better to be safe than sorry; and very importantly 4) don't expect the market to agree with you should you have any accounting concerns.
Comments on this investing in hindsight feature can be directed to the Versailles message board.
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