Jeyhun Ashrafov, Akshay Bansal, Philipp Garber, Vishal Gupta, and Tse-Lin Liu
A small debt produces a debtor; a large one, an enemy.
- Publius Syrus
Anybody without suitable accounting knowledge would be perplexed or even frustrated to hear about a multibillion dollar company that reports massive losses yet pays dividends to its shareholders. Such examples contradict our expectations.
Perhaps increasing public frustration with the corporate world stems from speaking different “languages.” In the case we examine here, the apparent contradiction stems from perceptual differences in the use of words. In accrual accounting, the net income of any company is not about the difference between cash received and cash spent. Rather, it is an indicator of the economic performance of the company. Whereas, the cash flow statement does just opposite by dealing only with cash activity. Therefore, it is actually not uncommon for a company to have positive cash flow, which enables it to pay dividends, while reporting an economic loss. So, let’s break down this “paradox.”
We chose Yamana Gold as an example of a company with negative income that pays dividends. The company has reported huge losses since 2013, while it continues to pay steady dividends. We will use its financial statements to identify the factors that affect its income negatively, and its cash flow statement to explain how it managed to pay dividends.
Yamana Gold produces and sells gold. Understandably, the company is heavily reliant on the gold price, which is very countercyclical. This means that it rises when the economy is weak and drops when the economy is strong. Higher gold prices yield huge profits for the company, but lower prices can bring it to the verge of bankruptcy. Fluctuations in the gold price expose gold companies to great financial risks.
The graph below shows the gold price since 2012:
How is this price trend reflected in Yamana Gold’s revenues? Here are the company’s sales figures for the same period.
As the gold price dropped from $1664 an ounce in 2012 to $1060 an ounce in 2015, the company’s gross margin dropped from 64% to 40%. Revenue declined with the drop in gold price, but cost of sales increased by 30%, leading to the overall gross margin reduction. At this point, loss mitigation strategies, such as laying employees off to reduce labor costs and increasing automation to boost efficiency, were developed. However, the direct damage to net income caused by the lower gold price was just the beginning. It had further implications for company’s assets. How?
Asset Impairment in Theory
IFRS requires companies to evaluate their asset values each year. The purpose of this is to show stakeholders a realistic picture of the company’s current financial situation. Balance sheets can contain assets that were purchased during strong market conditions. These assets may not be capable of producing a profit when the market weakens.
With the current unfavorable economic conditions, Yamana Gold’s assets do not have the same market value as when they were purchased. When assets do not promise the same economic returns that they did at high-price times, book values exceed fair market value. During low gold price, mines become less lucrative, What a gold mine produces may not even exceed the operating costs incurred. Presenting these mines on the balance sheet at the existing book value would therefore mislead investors.
Mining companies are exposed to volatility in commodity prices. This volatility has an dramatic impact on the balance sheet because the company must re-assess its reserves, which depends on gold prices. Reserves are the amount of minerals a mining company can extract from its mines profitably. All reserves are worth less at lower gold prices and would see a proportional write-down, but some mines may suddenly become uneconomical and their entire value can be written down.
This explains why Yamana Gold had large losses, far beyond what one would expect looking only at the declining gross margin. It booked large impairments on several of its mining assets.
It can be seen from the graph above that there was 36% decline in gold prices since 2012. Under IFRS regulations for accounting that came into effect in 2011, companies can write impairment amounts back up, should the conditions that led to the impairment become favorable. This could be one reason for the $2.5 billion impairment in 2015, since there was no significant price change over the year. Under IFRS, impairments are not necessarily permanent.
When used properly, impairments serve a very compelling purpose. As stated, assets written down to their fair value reflect a more realistic picture of financial position to investors.
Asset Impairment in Practice
Unfortunately, impairment is not always used as the regulators intended. It provides an opportunity for managers to manipulate the balance sheet. One mechanism to prevent this from happening is auditing. Managers must justify both the original impairments and any reversals to the auditors. However, due to information asymmetry, it can be nearly impossible to determine the extent to which Yamana Gold’s impairments happened at management’s discretion. How did it happen that there was only a small change in gold price but assets were impaired dramatically? Is this a proactive decision taken by Yamana Gold’s management or was it simply that the company could no longer resist the pressure of the market?
Yamana's Asset Impairment
There could be several reasons for such a large amount of impairment:
- The impairment might reflect management’s further pessimism about the gold price in the foreseeable future.
- Tax recovery of $647 million, related to the impairment, has a positive impact on net income.
- The commitment fee on the non-utilized portion of Yamana Gold’s revolving credit facility is contingent on its credit rating, which in turn may depend on its asset ratios. Currently, the commitment fee varies between 0.24% and 0.45%. Therefore, Yamana Gold may have deliberately delayed writing down its assets to keep the commitment fee lower. Unfortunately, the company does not communicate well about these matters.
- Impairments may be timed to economic downturns, which partially shifts the blame from management to the economic conditions.
- Managers can reverse these impairments when conditions are favorable, which in turn boosts net income.
How does the impairment charge affect overall picture? How does it affect dividends? Below is a portion from Yamana Gold’s income statement showing the effect of the impairment charges:
Impairment is a major contributor to the operating loss. There was no impairment in 2012, proving the clear relation between gold price and impairment. Impairment does not mean a cash loss, but indicates the decline in asset value (Balance Sheet) and a loss in income (Income Statement).
Impairment further affects net income, as the income loss will increase the tax asset or decrease the tax liabilities of the company. When assets shrink, so does deferred tax liability, because of the emerging tax benefit, and vice versa when assets increase in value. In Yamana Gold’s case the asset size declined by $ 2.5 billion, which brought about $647 million tax benefit. Hence, Yamana Gold’s deferred tax liability decreased from $2.5 billion in 2014 to $1.7 billion in 2015.
Income tax recovery therefore buffers net income by partially offsetting the effects of impairment on the income statement. However, the income statement still ended up with $2.1 billion economic loss at the end of 2015.
Now, let’s look at cash flow statement to see how it is affected. We start with cash from operations, which is calculated in part by adding back all non-cash expenses to net income. This is where radical differences arise. Adding all those numbers back shows that the company had a powerful $531 million operating cash flow. But on the balance sheet, only $119 million cash was retained. Usually a major part of operating cash flows goes into investment activities. Companies sustain their growth with sound investments. Yamana Gold’s cash flow statement tells us that the company spent $392 million for investment activities in 2015, leaving the company with cash of around $127 million.
At this point, the company needed to generate cash somehow. There were interest expenses of $114 million coming up and the company wanted to reduce its reliance on its $1 billion revolving credit facility, which has a commitment fee ranging from 0.29% to 0.43% of the non-utilized portion. The company got this debt upon the purchase of Osisko in 2014.
One might ask why the company would purchase another company for $1.5 billion in the midst of the mining industry crisis? The answer is relatively simple. Mining companies’ primary assets are gold reserves. The longer the mines are used, the more they lose value and productivity. Mining companies need to constantly add high-grade reserves to their portfolio to sustain their operations. In high-price times this serves to increase profit, but in low-price times this becomes a matter of survival, since they need to sell more gold to benefit from economies of scale. In this regard, Canadian Malartic is a rising star in the Yamana Gold portfolio, as some of Yamana Gold’s other mines are closer to the end of their economic lives.
It is interesting that in 2014, the company declared $107 million in dividends and then increased the amount to $143 million, much to the shareholders’ surprise, despite having huge economic losses. This decision gives the impression that the company wanted to earn shareholders’ confidence. Then, in 2015, restricted by limited cash inflow, the company declared $55 million in dividends, lower than the previous year but perhaps with the same agenda of keeping market confidence. As a result, the company was able to raise $228 million from a share offering. With $191 million cash at the beginning of the year, the company paid back $687 million in debt while issuing another $426 million of debt. The company ended the year with $119 million cash.
As we have seen in the case of Yamana Gold, impairments affect a company’s revenues negatively, resulting in the disclosure of an economic loss while not having an impact on cash flows. We also saw that while there is no simple cause-and-effect relationship between the cash flow statement and the income statement, in the long run they cannot be evaluated independently of each other. In our case, impairments started from 2013 and severely affected the income statement in 2015. A company with shrinking asset values and declining economic performance cannot sustainably continue to provide cash. Either commodity prices need to increase, or asset quality and related operational efficiency need to improve, in order to survive. Since the price of gold in not within the control of the company, it must reduce its costs and increase its sales volume. Cost reduction requires further automation, which is expensive, and lay-offs, which come with large severance payments. More production also needs high-quality reserves to extract profitably, but acquiring these reserves is also cash-thirsty.
While paying dividends could be perceived unwise at most, it cannot be sustainable in the long run, as the market conditions will not tolerate it too long. Banks and other financial institutions will not be likely to lend money to a shrinking company, which in its turn means less liquidity and shrinking cash flows.
About the Authors
Jeyhun Ashrafov comes from a manufacturing background. He has 11 years of experience in various fields. He worked at Volkswagen for two years, then with a bank, and then became General Manager of construction company, until he chose to do his MBA at Schulich. He is passionate about manufacturing operations. He obtained his Bachelor's degree in Public Administration from University of Trace in Turkey.
Yamana Gold's 2012 - 2015 Annual Reports.
Image is from the cover of Yamana Gold's 2014 annual report.