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Should Best World International Limited Investors Be Worried About Financial Manipulation?

Best World International Limited‘s (SGX:CGN) share price has increased by over 3,400% in the last five years. This makes Best World one of – if not the best – performing stocks in Singapore’s market in that time frame.

But, Best World was thrown under the spotlight in recent months. It all began on 18 February when an article was published on the Business Times questioning the legitimacy of the company’s business and sales figures in China. Best World requested a trading halt on the same day, made clarifications regarding the Business Times article on 23 February, and only lifted the trading halt on 25 February.

But the company’s actions did not stop its share price from dropping by 32% from S$3.25 on 15 February (the last trading day before the Business Times article was published) to S$2.21 on 25 February. The next day, Best World reported positive earnings results for the fourth quarter of 2018. The company’s share price rebounded, but it was not a full recovery.

With all that has happened, I decided to do a little digging to find out how reliable the company’s sales figures really are and whether investors should be worried.

Is there a discrepancy between profits and cash flows?

Before we can make any conclusions about the prospects of a company, we first need to determine if its financial statements and sales figures are legitimate. A company that is inflating its sales numbers or market position will limit the actual usefulness of its financial statements.

The article published on Business Times not only questioned the legitimacy of Best World’s sales figures and market position in China, but also question whether the company’s franchisees in China truly existed. Although investors in Singapore have limited resources to physically substantiate these claims, we can compare figures in Best World’s financial statements to give us clues on whether the company has been manipulating its earnings figures.

The first thing to compare is the profit and cash flow. Eyebrows should be raised if a company’s cash flow from operations is meaningfully lower than its earnings. The reason for this is because cash flow statements are harder to manipulate, while earnings and revenues are more easily gamed by the company’s actions, such as by providing generous credit terms or lax return policies.

In 2018, Best World’s profit before tax was S$93.1 million, while its cash flow from operations (excluding working capital changes) was S$94.7 million. The high cash flow from operations is a good indicator of reliable profits. In its response to the Business Times article, Best World also highlighted that sales to its franchisees in China were on a cash-basis and have a no-refund policy.

Dividends provide investors with more confidence

Another way that a company can instill investors’ confidence in its accounting is by paying dividends to shareholders. Consistent dividends to shareholders is a good sign that a company has sufficient cash or is generating positive cash flows. On the contrary, a company that has been consistently inflating its profit figures will not be able to pay out dividends as it will eventually run out of cash.

For 2018, Best World proposed a final dividend and special dividend of 4.2 Singapore cents per share and 0.8 Singapore cents per share, respectively. Together with the interim dividend of 1.2 Singapore cents per share and another special dividend of 1.2 Singapore cents per share declared in the third quarter, Best World’s total dividends for 2018 comes up to 7.4 Singapore cents per share.

The dividend equates to a reasonable payout ratio of 0.55 based on earnings per share of 13.26 cents for the year. Best World’s dividends for 2018 should instill confidence on the reliability of its profit figures.

The Foolish conclusion

From where I stand, the figures on Best World’s financial statements for 2018 do not look out of place. The fact that the company has been consistent in paying dividends and provided another dividend bump based on healthy 2018 results is also a good indicator of the reliability of its financial statements.

Best World’s response to the Business Times article, in my view, also sufficiently answered many of the questions raised about the company’s franchise model. In addition, Best World has taken steps to increase transparency for shareholders, such as making the appropriate changes to its website to include the names of franchisees.

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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 Jeremy Chia doesn’t own shares in any companies mentioned.