The Going Concern Principle

One of the most basic assumptions in accounting is the Going Concern Principle.  Stated simply, this is the belief that the entity/company in question will remain in business for the foreseeable future, and not be forced to liquidate in the near term.  Although not stated specifically in GAAP, auditors will frequently  review certain characteristics of a company to ensure that it can continue to operate under this assumption.  Examples of red flags in a company that might harm this assumption are things like poor trends in operating results, loan defaults, uneconomical long-term commitments which the company is subjected to, or even legal proceedings.(1)  Although it isn't stated specifically, I would add "presumably reckless financial behavior, over and beyond the company's stated operations" to the list of red flags that jeopardize the Going Concern of a given particular business. 

When I first typed this post, I didn't have the word "presumably" in the phrase above.  It was only after I re-read my commentary did I realize that it is arrogant to assume we know what is best for a company from the outside - although we do it all the time.  There could be a very good reason why a company behaves in a particular way, and we would hope that the company would come out to state that reason.  Lately, however, there have been a lot of actions that makes us raise an eyebrow.

A company that recently released earnings results made me raise an eyebrow.  Big miss top and bottom line, and Q4 revenue far below estimates with EPS a loss of .19 (also considerably below estimates).   Poor results are not why I am mentioning this company (I am not specifically mentioning it by name) - lots of companies are having hard times with commodity pricing, FX, etc.  Cash from operations is also strong, at $3.1 billion, the same as in fiscal year 2014. Free cash flow was a source of $2.1 billion in fiscal year 2015, compared with a source of $959 million in fiscal year 2014.  Then I see that this very company spent more than the last two years ($7.1B) in stock buybacks.  Hmm.

If you read my previous post where I discussed buybacks a little more in detail, you'll remember this chart:

...you'll also note that companies tend to make poor decisions on when to buy back stock, usually buying it near or at highs for poor returns.  The company I am talking about is no exception.  During it's $7.1B buyback period, it's average stock price was approximately $110 a share.  Right now, it trades at $86.50.  Those of you who are math wizards already realized that this is a lousy return of -21%.  Oh, and this company also just announced that it is going to continue this excellent strategy of buying another $3B in stock back through another reauthorized repurchase program.  And they're going to fire 2600 employees in the next year and a half.

This company is certainly not the only one doing this.  According to FactSet Fundamentals:

  "Although the aggregate dollar-value of share buybacks declined sequentially in the second quarter on a TTM basis, companies in the S&P 500 still spent more on buybacks than they generated in free cash flow. Free cash flow is defined as cash from operating activities minus capital expenditures from fixed assets and cash dividends paid. The aggregate Buybacks to Free Cash Flow ratio for the S&P 500 exceeded 100% for the first time since October 2009. The ratio hit 108% on a TTM basis at the end of Q2, which represented a 12.9% increase quarter-over-quarter and a 42% increase year-over-year. The 10-year median ratio was 72.2%.

 What is driving this ratio to such high levels? As mentioned earlier in this report, the TTM dollar-value share repurchases in Q2 amounted to $555.5 billion, which was a 1.3% increase year-over-year. This partly contributed to the higher ratio, but the main driver was free cash flow. TTM free cash flow at the end of Q2 totaled $514.4 billion, which represented a 28.6% decline year-over-year. The aggregate FCF for Q2 was the lowest level for the S&P 500 since Q3 2009, when FCF amounted to $140.2 billion."

You read that right.  Free Cash Flow drops 29%, and buybacks are barely impacted - still at multi-year highs.

Again, this isn't to say all buyback deals are bad.  But there are certainly quite a few where I have to ask:  What are we doing to our corporate future? Is the best use of our cash to buy back stock at highs?  What about investing in innovation?  Buying a competitor?  At what point do we remember the Going Concern is our mandate to ensure a successful business operation into the foreseeable future?

Thank you for reading.  I welcome your comments/criticism.

1-  https://www.accountingtools.com/going-concern-principle