Imagine your financial adviser suggesting you put money into a company whose revenue has grown 40 per cent, its profit has increased 30 per cent, yet 90 per cent of its revenue is trade receivables.
You would promptly slam the phone on him. What good is a profit figure if the money is not in the bag?
The independent financial adviser of Huiyuan Juice, however, does not seem to go by this rule of thumb. It is advising minority shareholders to pay HK$4.9 billion to controlling shareholder Zhu Xinli to buy a fruit puree maker that Zhu owns.
It is not for nothing that the Hong Kong stock exchange is considering tightening its grip on independent financial advisers and making them more accountable for their recommendations.
The so-called "independent" tag is quite misleading. Independent advisers do not do any "independent" investigation into the businesses and affairs of acquisition targets. Other than the audited report, they form their opinions solely on the basis of documents, information and views prepared and expressed by the management.
In return, they get a fee ranging from HK$150,000 to HK$1 million, depending on the size and complexity of the acquisition. Seven out of 10 of these advisers have been rehired by the same companies within three years of the acquisitions, according to a 2012 study by the Listing Committee of the Hong Kong stock exchange.
Huiyuan's independent financial adviser, Somerley, which has had no previous dealing with the juice maker, is similarly reliant on the management.
"We have relied on the information and facts supplied, and the opinions and intentions expressed, by the directors and management of the group and have assumed that they are true, accurate and complete," Somerley said in its report.
The problem is, even if one were to go solely by the management's version, the numbers still raise a lot of questions.
Zhu's puree maker is Huiyuan's largest raw material supplier. As of the end of last year, it had 1.32 billion yuan (HK$1.66 billion) in trade receivables - 95.6 per cent of its sales. It was worse than in 2011, when 71.09 per cent of its sales were outstanding dues.
The result: a "very profitable" company with a very weak cash flow: 125 million yuan of operating cash shortage in 2011 and 43 million yuan of cash inflow in 2012.
On this, Somerley said: "As advised by the management of the target group, the significant increase in trade and other receivables as at 31 December 2012 was mainly due to the increase in credit sale of fruit juice concentrates and purees to third-party customers close to the year-end.
"An independent sales team, being responsible for promoting third-party sales, was newly established, and the credit sale to third-party customers was comparatively smaller in 2011."
That is important. If the management is explaining away the receivables with Huiyuan's own purchases, any fair-minded minority shareholder will ask if the purchases, which have resulted in a significant rise in Huiyuan's inventory, have anything to do with the growth in sales at Zhu's puree maker.
Let us look at the numbers. The puree maker's trade receivables increased 88 per cent, or 622 million yuan, last year. "Third party" only accounts for 40 per cent of that, Huiyuan is responsible for the majority. Huiyuan has not paid for 86 per cent of its purchases.
So Huiyuan, rather than the third-party customer, is the major contributor to the dramatic growth of trade receivables, going by the management's own version.
However, the independent financial adviser does not seem to worry.
Instead, Somerley said: "As at the latest practicable date, approximately 45.5 per cent of the trade and other receivables as at 31 December 2012 had been settled."
This provides little comfort. First, that is an unaudited number from the management. Second, that means 723 million yuan has not yet been paid, with half the year already gone. That is more than the trade receivables for the whole of 2011.
Quality of receivables and profit matters here, because the sole parameter for valuation employed by the financial adviser is price-earning ratio comparisons with other acquisitions. The higher the accounting profit, the higher the price to Zhu.
The independent financial adviser makes no comment on the earnings quality of Zhu's puree maker. The fact is, not much is going to show up in Huiyuan's 2013 earnings because of the mode of accounting. This is because everything will be consolidated.
Once the acquisition is completed, the sale and purchase between Zhu's puree maker and Huiyuan will become an inter-departmental thing.
That is why the trade receivables of Huiyuan, which stand at 1.4 billion yuan, will only grow to 1.8 billion yuan after the acquisition, according to the unaudited pro forma financial statement of the enlarged group, including the puree maker.
One thing does matter, though: whether the company is paying a fair price to Zhu. The independent adviser's report does not offer much on that for minority shareholders.