During the past six months, the bankruptcies of Carillion and Conviviality have rocked the London market. The declines are notable not for their scale, but for the speed these businesses became insolvent.
It was only a few weeks from the first profit warning to the announcement that administrators had been called in at Conviviality. And while Carillion's demise was more drawn out, the company called in the administrators only three days after management announced that the firm remained in "constructive discussions" with creditors.
When things go south so fast it's very difficult for the average investor to get out before suffering a total loss. The best solution is it to avoid companies like these altogether, a process that's easier than it first appears. Indeed, both Carillion and Conviviality had several similar undesirable qualities that were on display long before the initial troubles emerged.
Cash is king
The first red flag for investors should have been the lack of cash flow from these two companies. In Conviviality's results for the six months to the end of October, the company announced total revenues of £836m and a pre-tax profit of £6.4m. But it generated just £528,000 of cash from its operations.
Meanwhile, according to a House of Commons report published after the company's collapse, Carillion generated only £159m of cash from operations between 2012 and 2016. Over the same period, the firm reported a cumulative net profit of £756m and paid a total of £376m to investors via dividends.
The next two red flags are interlinked. Both Carillion and Conviviality had reasonably similar business models. They had to pay suppliers upfront for goods and services, while only getting paid themselves when the job was completed, or product sold. This means they relied heavily on the kindness of strangers, creditors and suppliers. Short-term financing, as well as a good deal of trust, is needed for this type of business model to succeed.
Unfortunately, when analysts start asking questions about a company's financial viability, vital financial lifelines quickly evaporate, and so does trust. Therefore, it's imperative that these types of businesses maintain liquidity, unleveraged balance sheets. Borrowing hundreds of millions of pounds to finance a string of acquisitions is undoubtedly not the best course of action. But this is precisely the course of action both companies decided to take. Carillion and Conviviality borrowed heavily to finance acquisitions, which they struggled to integrate. As debt grew, cash flow only deteriorated.
Cash tells all
The one factor linking all of these terminal factors is cash. Had both companies focused on cash generation and built a liquid, cash-rich balance sheet, then it's more than likely that they wouldn't have failed.
So considering the above, the key lesson to take away from these two disasters is, quite simply, cash is king. As investing is not a precise art, it's unlikely you will ever be able to avoid suffering a significant loss in your portfolio. However, you can tilt the odds in your favour by avoiding highly levered companies that lack cash resources.
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Rupert Hargreaves owns no share mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.