If Capita stopped trading today, its creditors and shareholders would be in for an unpleasant surprise. On its most recent balance sheet, Capita had £668 million more liabilities than assets – in other words, it had negative equity.
What’s more, of the assets it does have, many would be hard to sell. Over a third of the total is ‘goodwill’ (£2.2 billion). Goodwill is an intangible asset, the value of which can decline rapidly if a business is perceived to be in trouble.
On 31 January 2018, Capita announced it would seek £700 million of new capital from shareholders. The sum would plug the equity hole in the balance sheet, but not much more.
Investors reacted by selling shares, which lost 55% of their value in two days.
How did Capita lose £1.2 billion of equity?
At the end of last year, Capita’s equity was a positive £483 million. So how did Capita lose £1.2 billion in the space of six months? The surprising answer is that it didn’t; rather, that money wasn’t really theirs in the first place.
How companies present their accounts is governed both by legislation and by what are called accounting standards. From time to time these standards are revised. A new standard, IFRS 15, requires companies to book revenue on contracts based on the flow of benefits received by the client, not the flow of costs incurred by the company. This change particularly affects companies with long-run contracts as their standard business activity. IFRS 15 became mandatory for all listed companies on 1 January 2018, but companies were free to adopt it earlier.
The impact of IFRS 15 on Capita was highlighted in the company’s 2017 half-year statements (21 September 2017). Capita went from booking revenue on a contract according to how much it had spent (known as ‘percentage of completion’), to booking revenue according to how much benefit the client had received.
In Capita’s words: “This reflects an important change in accounting policy as the Group moves from one based predominantly on percentage of completion revenue recognition to a methodology that is focused on aligning revenue recognition to the delivery of solutions and value to its customers.”
The difference between Carillion and Capita is that events forced Carillion to reveal that it had lost £1.2 billion when its optimistic forecasts were not met. IFRS 15 forced Capita to reveal what could happen if its forecasts are not met in future. If all goes well, the £1.2 billion that Capita has booked but hasn’t earned yet will eventually be Capita’s.
But the fact that Capita issued a profit warning on 31 January 2017 suggests that all is not well. This would matter less if Capita was well capitalised, but we’ve learnt from IFRS 15 that Capita has less than nothing to cushion losses (negative equity). It has its clients’ money, paid in advance.
To be clear, IFRS 15 doesn’t change Capita’s cash balances. What it changes is who those balances belong to.
Doesn’t Capita have a lot of cash, though?
According to the half-year statements, Capita had £1.1 billion of cash on 30 June 2017. However, the half-year statements don’t tell us what the net position is. Looking back at the full 2016 accounts, we can see that almost half of Capita’s cash came from overdrafts. Net of overdrafts, Capita had £566 million in the bank on 31 December 2016.
That is still a decent sum. But, perhaps, not so large, if one considers that Capita said it expected to lose cash in 2018. The announcement lists outflows adding up to £525 million.
What about those dividends?
Capita announced it was suspending dividends ‘until Company generating sustainable free cash flow’. Capita last paid £74 million of dividends on 30 November 2017, and £137 million in July 2017. In 2016 and 2017, the total paid out adds up to £425 million (Annual Report 2016 and dividend calculator 2017).
Capita’s ‘significant decision to suspend the dividend’ may be significant, but it was a decision made for them by circumstances, rather than a free choice. Companies can only pay dividends out of the money they have in their ‘distributable’ reserves (section 830 and 831 of Companies Act 2006). Capita had minus £1.3 billion of distributable reserves in its most recent balance sheet. The company cannot lawfully pay a dividend for as long as that balance remains negative.
It seems that Capita was able to make its 2017 dividend payments because the law states that distributions to shareholders must be justified by reference to ‘relevant accounts’ (sections 836 – 839) – and the relevant accounts are normally the company’s last official annual accounts (836(2)).
On 30 May 2017, the company confirmed it had adopted IFRS 15 from 1 January 2017. On 23 September, they restated their 2016 distributable reserves to minus £1.1 billion. Had Capita adopted IFRS 15 in its 2016 accounts, it would probably have been unable to make any dividend payments in 2017. That would have saved the company £211 million, or 30% of the £700 million it is now seeking from shareholders.
IFRS 15 has radically changed the way Capita looks. It will be interesting to observe what impact it has on other large contractors.