Can you trust the numbers that highflier Under Armour (NYSE: UA ) is putting up? The stock has been on quite a run as it sits near all-time highs. Here's one reason you should take a deeper look.
The vast majority of companies use accrual accounting instead of cash accounting. Accrual accounting allows a company to book revenue independent of the cash movement related to the transaction. This allows more appropriate matching of revenues and expenses that don't rely on the timing of cash flows. For example, if a retailer sells a widget on credit, it will recognize the revenue from the sale and increase its accounts receivable prior to collecting cash.
A potential warning sign arises if a company begins using accruals aggressively to recognize revenue. If the company isn't able to collect cash for all its sales, accounts receivable will tend to start growing faster than revenue.
In order to see how heavily a company relies on accruals, you can calculate an accruals ratio based on either the balance sheet or cash flow statement. Using the balance sheet, you divide the change in net operating assets by the average net operating assets over a period. Net operating assets consist of the difference between operating assets (total assets less cash) and operating liabilities (total liabilities less total debt). I prefer to use full-year data since it gives a broader view of a company's financial position. A higher ratio implies lower quality earnings.
|lululemon athletica (Nasdaq: LULU )||5.9%||57.1%||10.7%|
|Nike (NYSE: NKE )||13.3%||9.7%||18.4%|
|The Gap (NYSE: GPS )||4.3%||3.3%||36.7%|
Source: Annual reports, figures for most recent full fiscal year.
You can't pay bills with accounts receivable
A high accruals ratio combined with accounts receivables growth outpacing revenue growth is not sustainable in the long run. Eventually, you need cash to operate. If this trend were to continue or get worse, I would exercise extreme caution. It's also worth noting that Under Armour has been having a problem generating free cash flow. Not even having a strong brand image will help you unless you can back it up with dollars in the bank.
These facts alone won't tell you the whole picture, but they do warrant a closer look. Under Armour is putting up some impressive headline figures, but the numbers behind the headlines are what bother me. I wouldn't invest until these underlying issues are addressed once and for all.