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Evergrande: Not So Grand Financial Statements?

Evergrande Group is the latest listed visitor to unexpectedly teeter on the verge of bankruptcy.

When businesses are thrust into public view for the wrong reasons, my first thought is unchangingly whether we could have seen the trouble coming superiority of time.

As a qualified accountant, I treat the audited financial statements as my first port of undeniability on this question. Many dismiss these as obsolete, incomplete, opaque, and manipulated, and while there is some merit to such critiques, these statements can reveal quite a lot well-nigh whether trouble may be on the horizon.

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To see if Evergrande’s travails could have been anticipated, I looked at its yearly reports for five years, from 2016 to 2020.

So what did I discover? Should we have seen the Evergrande storm brewing?

Evergrande Growth Falls Off a Cliff

  2016 2017 2018 2019 2020
Revenue, in Millions Renminbi (RMB) 211,444 311,022 466,196 477,561 507,248
Revenue Growth 59% 47% 49% 2% 6%

Evergrande’s revenue growth fell unceasingly from 59% in 2016 to 2% in 2019 surpassing recovering to 6% in 2020. The largest waif occurred between 2018 and 2019, when it declined from 49% to 2%.

This is troubling since rapidly slowing growth is increasingly than just a warning sign: It can moreover incentivize bad policies in the form of both written tricks and risky merchantry practices in an effort to make the hair-trigger top and marrow line numbers squint pretty.

The Specimen of the Disappearing Margins

Change, 2017 to 2020 2016 2017 2018 2019 2020
Gross Profit Margin (GPM) -12% 28% 36% 36% 28% 24%
EBITDA Margin -14% 20% 30% 30% 20% 16%
Operating Profit Margin (OPM) -15% 20% 29% 30% 20% 15%
Net Profit Margin (NPM) -6% 8% 12% 14% 7% 6%
Selling and Marketing Expenses, in Millions RMB 86 15,983 17,210 18,086 23,287 31,962
Selling and Marketing Expenses as Percent of Revenue 2% 8% 6% 4% 5% 6%

Evergrande’s margins didn’t do well either. Gross profit margin (GPM), EBITDA margin, operating profit margin (OPM), and net profit margin (NPM) all decreased between 2016 and 2020.

The most worrying ripen was the GPM slump. GPM fell by 12% over just three years, from 2018 to 2020. The Management Discussion and Wringer section of Evergrande’s yearly report explains why:

  • According to the 2020 report, “Gross profit for the Year decreased mainly due to a subtract in the stereotype selling prices caused by the nationwide sales promotion activities and sales price concessions of the Group as a result of COVID-19.”
  • The 2019 report stated, “Gross profit rate was 27.8% for the Year, which was mainly due to the lower selling prices of clearance stock properties and the slight increases in construction and installation financing per square meter for delivered properties, land financing and interest capitalized.”

Translation: The fall in GPM was mainly due to sharp cuts in selling prices to push property sales.

As the table shows, the other margins not only fell, they were almost cut in half.

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This swoon in margins was driven, of course, by slowing GPM. But increasing selling and marketing expenses were hair-trigger contributing factors as well. These expenses not only rose as a percentage of sales over the last three years of our sample, they moreover ballooned by 86% between 2017 and 2020. The main reason? An effort to kickstart rapidly flagging sales. This may have been an indicator of the larger issue: serious sectoral weakness.

Big Swings in Mazuma Flows, in Millions RMB

  2016 2017 20ed18 2019 2020
Cash Spritz from Operations (CFO) -58,610 -150,973 54,749 -67,357 110,063
CFO surpassing Interest Payments -27,734 -96,901 109,837 -566 188,097
Free Mazuma Spritz to the Firm (FCFF) -44,063 -111,696 99,487 -15,729 169,791

The accrual method can help obfuscate weakness in the income statements, but mazuma flows are far less susceptible to such manipulation. So while Evergrande’s revenues rose and its profits stayed unappetizing over the five-year sample, the firm’s mazuma flows tell a variegated story. Both CFO and self-ruling mazuma spritz to the firm (FCFF) kept swinging from negative to positive and when to negative. But we’ll get to those swings later.

The CFO should be positive. Otherwise, it indicates that the visitor is unable to make money from its operations. An erratic CFO ways that the firm may be at the mercy of lenders just to fund its operations.

Moreover, the trend of volatility and negative CFOs doesn’t transpiration plane if we squint at CFO before interest payments: Evergrande’s personnel operations were often gory cash, plane without written for interest payments.

The Magic of Big Accruals

  2016 2017 2018 2019 2020
CFO, in Millions RMB -58,610 -150,973 54,749 -67,357 110,063
CFO/Net Income -3.33 -4.07 0,82 -2.1 3.5

The CFO to net income ratio is both rarely used and quite revealing. As such, it is one of my favorite indicators.

Net income is a mix of accruals and cash, while CFO is pure cash. So this ratio tells how much of the booked profits for a year were received in cash. In healthy firms, this ratio will be unappetizing or rising. A falling or volatile ratio indicates an unusually upper value of accruals and thus both are alarming.

Evergrande’s ratio was highly volatile. Why? Not considering net income over the past five years was largely unappetizing in wool numbers, but considering its CFO went up and lanugo like a yo-yo.

What caused the volatility of the ratio and CFO? An unusually upper value of accruals — i.e., non-cash items — in the income statement. That is a big fat red flag.

So what were these non-cash items?

Boosting Mazuma by Delaying Payments

When a firm delays payment to suppliers, it is often an struggle to perpetuate CFO in response to poor mazuma inflows.

The relevant indicator is the number of days payable outstanding (DPO), or how many days the forfeit of sales is lying unpaid. All else the same, an increasing DPO is troubling. Evergrande’s DPO jumped from 379 to 553 days over the past five years.

  2016 2017 2018 2019 2020
Trade Payables, in Millions RMB 182,994 257,459 423,648 544,653 621,715
Number of Days Payables Outstanding (DPO) 379 404 418 513 553

The company’s 2020 mazuma spritz statement shows that CFO soared from a deficit of RMB 67 billion in 2019 to a surplus of RMB 110 billion in 2020. That’s a net increase of RMB 177 billion. A big suburbanite of this mazuma surge? The bounty of trade payables. Trade payables rose by RMB 77 billion in 2020 over 2019 despite unthriving property construction activity.

That is unsustainable.

Robbing Peter to Pay Paul

The mazuma spritz statement reveals how Evergrande misallocated mazuma in 2020.

The adjusted CFO is a good starting point. It shows the effect of delaying payments to suppliers. If the increase in payables in 2020 had been the same as that in 2019, or RMB 29 billion, then 2020 CFO would not be a RMB 110 billion surplus but a deficit of RMB 16 billion: 110-155 29.

That’s an important number to pension in mind when we see that Evergrande repurchased RMB 4 billion in shares and paid RMB 59 billion in dividends in 2020.

Since the firm borrowed RMB 303 billion in 2020, we’d expect at least some of those funds paid for the share repurchases and dividend payments. But that was not the case. Repayments to lenders of RMB 398 billion outstripped that RMB 303 billion in new loans.

What does that mean? Payments to suppliers were likely delayed, boosting CFO mainly to pay dividends and buy when shares.

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Increasing Write-Downs

Evergrande held significant amounts of properties under minutiae (PUD) and properties held for sale (PHS) on its wastefulness sheet. In volume these rumored for approximately 60% of the firm’s resources as of year-end 2019 and 2020.

While PUD is self-explanatory, PHS is property that has been synthetic and is pensile sale.

Evergrande’s written policy requires PUD and PHS be written lanugo to their net realizable values (NRV) if their NRVs are less than the cost. This write-down totaled RMB 3.22 billion in 2020, a 39% increase from the 2019 write-down of RMB 2.32 billion which itself was a 132% increase from the 2017 write-down of RMB 1 billion.

The write-downs may not be huge in the context of Evergrande’s revenue or windfall numbers, but the relative increases are material. They most likely indicate a deteriorating market for the firm’s properties. The trend probably commenced in 2017 and is reflected in the slowing sales growth.

Bankers See the Rising Risk First

Evergrande’s note to finance mentions the weighted stereotype rate of the company’s unstipulated borrowings. This is used to capitalize interest costs. This rate had been increasing since 2017.

Evergrande’s Borrowing Costs

2016 2017 2018 2019 2020
8.27% 8.09% 8.11% 8.63% 9.46%

Now, this rate could increase for only two reasons: either a rise in the unstipulated lending rate in China or increased credit risk on the part of the borrower.

China’s prime lending rate has stayed unappetizing since 2017, dropping only due to pandemic-induced stimulus efforts in 2020. Yet Evergrande’s forfeit of borrowing didn’t fall. Overall, its rate jumped by a significant 137 understructure points (bps) in three years. This suggests that lenders believed extending credit to Evergrande was an increasingly risky proposition.

Addicted to Debt?

Evergrande’s overreliance on debt is the popular subtitle for its predicament. But the firm’s nuts-and-bolts debt-to-equity ratio unquestionably declined between 2016 and 2020.

  2016 2017 2018 2019 2020
Debt to Equity 2.78 3.02 2.18 2.23 2.04

This unconvincing trend has an easy explanation, however: It is solely due to probity jumping from RMB 193 billion in 2016 to RMB 350 billion in 2020. To a unstudied analyst, that may not have raised any red flags.

(Evergrande’s probity increased for two main reasons: The firm uninventive majority — but never 100% — interests in subsidiaries. So the resulting amounts of non-controlling interests (NCI) kept increasing group equity. Secondly, these NCIs kept injecting mazuma as equity.)

So how could we have discovered that Evergrande’s debt problem was worsening?

Two calculations requite us insight on this question. In both cases, the higher the number the better.

  1. Total debt to CFO reveals how long a firm would need to pay off existing loans if current CFO held steady.
  2. Total debt to FCFF indicates how much time it would take to repay the debt if current FCFF was maintained.

For Evergrande, both of these ratios were extremely volatile and negative in three of the five years.

  2016 2017 2018 2019 2020
Total Debt to CFO -19 -8 6 -1,413 4
Total Debt to FCFF -12 -7 7 -51 4

An Accident Waiting to Happen

The Altman Z-score formula measures how tropical a visitor is to bankruptcy. The Z-score considers five ratios, each of which addresses one of five considerations: profitability, leverage, liquidity, solvency, and activity. The lower a firm’s Z-score, the greater the likelihood it will go bankrupt. A Z-score unelevated 1.8 indicates a upper probability of bankruptcy, while one of 3 or whilom indicates a firm is in the unscratched zone and should stay solvent.

From 2016 through 2020, Evergrande’s Z-score was less than 1. Its Z-score for the five years averaged 0.77 and dropped from 0.81 in 2017 to 0.62 in 2020.

Of the five Z-score ratios, those measuring worriedness and profitability either stayed the same in the latter specimen or rose in the former. The visitor was thus profitable and efficient. Why? Considering both ratios are driven by revenue, which is accrual based and easier to “produce.” What fell were the liquidity and solvency ratios. Which makes perfect sense given the massive borrowing and the mazuma crunch.

A big takeaway in this wringer is to be wary of drawing big conclusions from any ratio that includes a revenue number.

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Conclusion

So what could we have pieced together from examining Evergrande’s audited financials?

Altogether our wringer reveals a story of rapidly slowing growth, rising expenses, shrinking margins, shoddy quality of earnings, and mazuma spritz deficits that were plugged by delaying payments to suppliers and vast borrowing, the forfeit of which kept rising.

Debt defaults, bankruptcies, etc., never happen “suddenly.” They’re less like a lightning strike than a long-term illness. Heart disease and other such maladies tend to operate in stealth mode for much of their life cycles, going invisible, and undetected and thus untreated. Yet during this time, they are slowly towers up and rhadamanthine increasingly and increasingly dangerous. By the time their symptoms explode into view, drastic treatment is required.

Yet Evergrande-like risks can be detected early. We just have to be curious enough.

For increasingly insight from Binod Shankar, CFA, visit The Real Finance Mentor.

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

Image credit: ©Getty Images / Getty Images / Stringer


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Binod Shankar, CFA

Binod Shankar is a CFA charterholder. He is a blogger, keynote speaker, executive coach, podcaster at The Real Finance Mentor, and appears wontedly on CNBC and Bloomberg as a market analyst. He moreover used to throne finance at a large property minutiae company.

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