Practical analysis for investment professionals
01 November 2021

Evergrande: Not So Grand Financial Statements?

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

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

As a qualified accountant, I treat the audited financial statements as my first port of call 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 about 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 annual 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

 20162017201820192020
Revenue, in Millions Renminbi (RMB)211,444311,022466,196477,561507,248
Revenue Growth59%47%49%2%6%

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

This is troubling since rapidly slowing growth is more than just a warning sign: It can also incentivize bad behavior in the form of both accounting tricks and risky business practices in an effort to make the critical top and bottom line numbers look pretty.

The Case of the Disappearing Margins

Change, 2017 to 202020162017201820192020
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+8615,98317,21018,08623,28731,962
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 decline was the GPM slump. GPM fell by 12% over just three years, from 2018 to 2020. The Management Discussion and Analysis section of Evergrande’s annual report explains why:

  • According to the 2020 report, “Gross profit for the Year decreased mainly due to a decrease in the average 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 costs per square meter for delivered properties, land costs 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 collapse in margins was driven, of course, by slowing GPM. But increasing selling and marketing expenses were critical contributing factors as well. These expenses not only rose as a percentage of sales over the last three years of our sample, they also 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 Cash Flows, in Millions RMB

 2016201720ed1820192020
Cash Flow from Operations (CFO) -58,610-150,97354,749-67,357110,063
CFO before Interest Payments-27,734-96,901109,837-566188,097
Free Cash Flow to the Firm (FCFF)-44,063-111,69699,487-15,729169,791

The accrual method can help conceal weakness in the income statements, but cash flows are far less susceptible to such manipulation. So while Evergrande’s revenues rose and its profits stayed flat over the five-year sample, the firm’s cash flows tell a different story. Both CFO and free cash flow to the firm (FCFF) kept swinging from negative to positive and back to negative. But we’ll get to those swings later.

The CFO should be positive. Otherwise, it indicates that the company is unable to make money from its operations. An erratic CFO means 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 change even if we look at CFO before interest payments: Evergrande’s core operations were often bleeding cash, even without accounting for interest payments.

The Magic of Big Accruals

 20162017201820192020
CFO, in Millions RMB-58,610-150,97354,749-67,357110,063
CFO/Net Income-3.33-4.070,82-2.13.5

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 flat or rising. A falling or volatile ratio indicates an unusually high amount of accruals and thus both are alarming.

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

What caused the volatility of the ratio and CFO? An unusually high amount 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 Cash by Delaying Payments

When a firm delays payment to suppliers, it is often an attempt to bolster CFO in response to poor cash inflows.

The relevant indicator is the number of days payable outstanding (DPO), or how many days the cost 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.

 20162017201820192020
Trade Payables, in Millions RMB182,994257,459423,648544,653621,715
Number of Days Payables Outstanding (DPO)379404418513553

The company’s 2020 cash flow 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 driver of this cash surge? The bounty of trade payables. Trade payables rose by RMB 77 billion in 2020 over 2019 despite declining property construction activity.

That is unsustainable.

Robbing Peter to Pay Paul

The cash flow statement reveals how Evergrande misallocated cash 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 keep 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 back shares.

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Increasing Write-Downs

Evergrande held significant amounts of properties under development (PUD) and properties held for sale (PHS) on its balance sheet. In aggregate these accounted for approximately 60% of the firm’s assets as of year-end 2019 and 2020.

While PUD is self-explanatory, PHS is property that has been constructed and is awaiting sale.

Evergrande’s accounting policy requires PUD and PHS be written down 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 asset 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 accounts mentions the weighted average rate of the company’s general borrowings. This is used to capitalize interest costs. This rate had been increasing since 2017.

Evergrande’s Borrowing Costs

20162017201820192020
8.27%8.09%8.11%8.63%9.46%

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

China’s prime lending rate has stayed flat since 2017, dropping only due to pandemic-induced stimulus efforts in 2020. Yet Evergrande’s cost of borrowing didn’t fall. Overall, its rate jumped by a significant 137 basis 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 explanation for its predicament. But the firm’s all-important debt-to-equity ratio actually declined between 2016 and 2020.

 20162017201820192020
Debt to Equity2.783.022.182.232.04

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

(Evergrande’s equity increased for two main reasons: The firm acquired 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 cash as equity.)

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

Two calculations give 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.

 20162017201820192020
Total Debt to CFO-19-86-1,4134
Total Debt to FCFF-12-77-514

An Accident Waiting to Happen

The Altman Z-score formula measures how close a company 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 below 1.8 indicates a high probability of bankruptcy, while one of 3 or above indicates a firm is in the safe 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 activity and profitability either stayed the same in the latter case or rose in the former. The company was thus profitable and efficient. Why? Because 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 cash crunch.

A big takeaway in this analysis 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 analysis reveals a story of rapidly slowing growth, rising expenses, shrinking margins, shoddy quality of earnings, and cash flow deficits that were plugged by delaying payments to suppliers and vast borrowing, the cost 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 building up and becoming more and more 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 more 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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About the Author(s)
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 frequently on CNBC and Bloomberg as a market analyst. He also used to head finance at a large property development company.

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