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IPO Window Dressing - Evaluate the True Financial Health of an IPO

8 mins 05 Dec 2023 0 COMMENT

Today, we'll discuss "Window Dressing." Window dressing is a technique that businesses use to make their products more appealing to consumers. For instance, almost every shop at an airport is filled with glamour, and all of us get attracted to these products, even feeling tempted to buy them, despite their high prices. This is an example of physical window dressing. Another type of window dressing is financial window dressing. While the ethics of physical window dressing can be debated, it is technically not wrong. However, financial window dressing is considered a deceptive technique where companies attempt to alter their financials to present a better or altered picture than reality. Financial window dressing can be achieved in several ways, sometimes due to industry-wide events or through clear manipulation of financial statements.

One time to be cautious about financial window dressing is during an IPO. Investors should carefully examine profits and other metrics to understand if improvements are structural or due to one-off events. Let's discuss some methods used for financial window dressing.

1. Recording revenue early

Companies may record revenue in the current year for sales anticipated in the next year or relax their credit policies to increase sales. This approach might risk cash flow, but profitability will likely improve.

2. Suppressing expenses

Companies may reduce their spending or defer certain expenses to future periods, which would enhance their profitability.

3. Industry Wide Events

The third situation is not company-specific but rather influenced by industry-wide impacts. Companies may try to launch their IPOs when there are industry-wide events. For example, after COVID, insurance sales increased, leading some companies to report stronger sales numbers, prompting them to launch IPOs.

Now, let’s understand these situations in more detail with examples.

1. Suppression of Expenses:

Certain operating expenses are fully under management’s control, and management may decide to defer these expenses to show enhanced profitability. For example, a famous beauty platform attempted this by significantly reducing its advertising and publicity expenses during its IPO year, which made its profitability appear improved. Studying trends is essential for investors, rather than relying solely on one-time figures.

2. Receivables Spike in One Year:

A company can sell products either on cash or credit. In cash sales, revenue recognition and cash flow happen simultaneously, but in credit sales, revenue is recorded immediately, and cash flow occurs later. If a company tries to artificially inflate revenue by on-boarding creditors with low creditworthiness, revenue may increase, but the company will bear unsolicited risk on its balance sheet. This happened with a crop protection company during its IPO year when receivables showed a sharp spike, suggesting potential window dressing.

3. Industry Trends Creating Illusions of Profitability:

Sometimes, industry trends can create a temporary spike in gross margins, which may not be sustainable in the future. In industries, gross margins are broadly range-bound, where commoditized businesses earn lower profits compared to differentiated businesses. Over here, a gradually upward movement can be possible due to product mix improvement, premiumization or improvement in business. But if the gross margin is improving drastically then it is might be a case of window dressing.

Factors behind window dressing:

  • Elevated prices of company’s existing inventory/stock.
  • Low supply rate leads to competitor exiting.

For example, a metal container and rack marketing company, which is a B2B and relatively low-value-added business, applied for an IPO during a high gross margin period. Such spikes are typically unsustainable, yet they can inflate valuations.

If you're interested in learning more, you may find the book “Financial Shenanigans” insightful. We hope this article helps improve your screening process. If you have any examples of window dressing, let us know in the comments, and don’t forget to share this blog with your friends! 

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