Predicting financial distress – The case of NMC
How to predict financial distress has been a challenging questions that concerned academics and professionals for a number of year. The current situation of NMC Health (LSE: NMC) is a case in point. After generating some incredible 5 years returns of more than 170%, and reaching £41 in August 2018, compared to the returns of the FTSE 100 index of 24%, it started being volatile over the last 2 years, and in the last three days, its shares are trading today at only £13, less than half its 52 week high of £29.40. The proportion of its shares that are shorted is close to 50%, one of the highest in the FTSE100 index.
Jefferies raised some accounting concerns last semester that lead to significant NMC stock price volatility. In particular, the analysts thought that, while there is no risk to NMC as a going concern, they believe that in core healthcare business, margins of 31.5% are 26.3% after exceptional, and cash flows increased due to supply chain financing, rising payables, and understating net debt to EBITA of 3x.
However, this week's drop in its stock price is driven by a report by Muddy Waters that reiterated the serious doubts about the NMC’s financial statements relating mainly to asset values, cash balance, profitability margins, and debt levels, namely the use of related companies to undertake some transactions and off balance sheet financing (operating leases) to hide debt. These problems are exacerbated by the firm’s inadequate governance system. If this is true, then it sounds like a repeat of the case of ENRON in 2001.
So far the managers are disputing these issues, and it is not clear whether they will lead NMC into distress and potential bankruptcy, worth following. However, the case illustrates the use of financial statements to predict possible financial distress, particularly when there is high information asymmetries, driven by opacity in information disclosure, inadequate governance and distance of the operating activity from shareholders/the market listing.