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Is Courts Asia Ltd Doomed To Fail?

Over the past 12 months, furniture and home appliances retailer Courts Asia Ltd (SGX: RE2) has had a torrid time with its shares declining by 40% to its current price of S$0.44. In comparison, Singapore’s market benchmark, the Straits Times Index (SGX: ^STI), had gained a modest 3% or so.

With Courts Asia’s latest quarterly results showing a 1.5% year-on-year decrease in revenue and a 27.9% slide in profit, it’s perhaps fair to say that the company’s drop in share price had much to do with the deterioration of its business.

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This share price decline experienced by the company might yet turn out to be an opportunity for bargain hunting if the deterioration in its business turns out to be temporal in nature. But, how can we know?

Predicting failure

My colleague John Maxfield’s recent article titled “Playing With Fire: A Framework for Predicting Failuremight help provide some answers to our question. The following is how John describes his framework for predicting the failure of retail companies:

“One of the reasons it’s hard to predict if and when a company will go under is because bankruptcy isn’t simply a matter of solvency — that is, of having more assets than liabilities. If this were the case, even a novice investor would be able to forecast the downfall of the most complex publicly traded corporation. All it would take is a cursory glance at the shareholders’ equity portion of the balance sheet.

This doesn’t mean solvency isn’t important; because it is. But it’s nevertheless rarely the precipitating cause of failure…

… If solvency isn’t the issue, what is? The answer is liquidity. When a company is in its final throes, the most acute problem it faces is the inability to convert assets into cash, which can then be used to buy inventory and satisfy expenses like rent and wages. This happens when creditors lose faith in a company and stop accepting its assets as collateral for lines of credit. It’s this, in turn, which triggers the actual demise.”

He followed up by explaining how he assesses a company’s liquidity:

“The fact that illiquidity is typically the cause of a retail company’s failure presents a problem for the average investor. This is because it’s far harder to compute than solvency.

The conventional approach is to compare a company’s current assets — such as cash, inventory, and accounts receivable — to current liabilities — namely, debts and obligations that will come due within a year. But this measure, known as the current ratio, can be misleading because it includes inventory and receivables, which often can’t be converted into cash at face value on sufficiently short notice, and because it ignores cash flow, which is the very essence of liquidity.

On top of this, there’s a subjective element to liquidity that can’t be captured in financial statements. This follows from the fact that a company’s liquidity depends on its creditors. And its creditors are less interested in shorthand measures of fiscal health like the current ratio, and much more concerned with beating competing creditors to the punch, thereby securing repayment before it’s too late.

It’s for these reasons that a retail company’s chances of suffering a fatal liquidity crisis can best be gauged with two questions. First, does the company have a history of sustained and accelerating quarterly losses? This matters because losses erode book value, which is a proxy for a company’s ability to borrow. And second, are the company’s operations burning through more cash than they’re generating? If so, then the company has a serious problem on its hands because its cash coffers aren’t being replenished — a fact that won’t go unnoticed by creditors.”

Pulling it all together

Now that we have a better idea of what to look out for, let’s put Courts Asia through the paces.

The company’s able to make it through the first test – “a history of sustained and accelerating quarterly losses” – splendidly. Courts Asia has not made any quarterly loss going back to at least the quarter ended 30 June 2011.

The second test though, is where things get a little dicey. Over the past four quarters (the 12 months ended 30 June 2014), Courts Asia’s operating cash flow was minus S$22.5 million; over the 12 months ended 30 June 2013, the company’s operating cash flow was S$9.8 million. Judging from the figures, it seems that Courts Asia is starting to feel the heat in its ability to generate adequate cash flow.

Foolish Bottom Line

We can’t tell for sure if Courts Asia’s business might be poised for a strong rebound, but the fact that it’s solidly profitable suggests that it can still survive to fight another day. That said, investors might want to keep a close eye on the company’s ability to generate positive operating cash flow in the future.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore writer Chong Ser Jing doesn’t own shares in any companies mentioned.