Real Returns. How to spot window-dressing

For equity investors, risks from competition, business cycles and market swings are par for the course. But one risk that has been cropping up far too often in India is that of companies window-dressing their financials. Retail investors often get the short end of the stick when accounting fraud comes to light. This makes it doubly important for them to have their antennae tuned to signs of manipulation in a company’s books.

Too high receivables

The stock market disproportionately rewards market leadership and scorching growth. Therefore, companies that cook their books often devote a lot of attention to inflating their toplines. Mismatches between reported sales and cash balances can be difficult to explain to auditors or investors. Therefore, companies window-dressing their numbers often counter-balance fictitious sales with receivables or debtors in their balance sheet.

When Satyam Computers confessed to its multi-year accounting fraud, it featured far higher receivables (₹2,651 crore) than other top-tier software peers. The company used fake invoices, non-existent clients and ghost employees to pad up its revenues. Suspicions of accounting manipulation at pre-school chain Treehouse Education snowballed after Stakeholders’ Empowerment Services, a proxy advisory firm, flagged the firm’s unusually high receivables. Given that pre-school chains collect fees in advance, it was unusual for Treehouse to report high receivables and doubtful debts (the company claimed it was from consulting).

To investors, a high percentage of receivables to annual sales and high debtors due for over six months (disclosures available in the balance sheet) should signal accounting anomalies. But given that some firms (those that deal with the government) and sectors (those that have elongated working-capital cycles) are prone to high debtors in the normal course of their business, it would be wrong to jump to conclusions based on a single year’s numbers. One also cannot prescribe an ideal debtors-to-sales ratio.

So, if the company you have invested in shows a high debtors-to-sales ratio, compare it with similar-sized industry peers to check if it is way off the norm. Be wary of a rising ratio over the years. And keep sector dynamics in mind. High receivables may be commonplace for a real estate developer or a hardware manufacturer, but not for a print media company or a software firm.

Cash versus profits

Most equity investors pore over a company’s P&L to assess its profitability. But as they say, profit is an opinion, while cash is a fact. A company’s net profits in its P&L can be bolstered through creative accounting policies on revenue recognition, revaluation of assets and loans, depreciation or provisioning. But the cash flow statement is far harder to mess with.

Check “cash generated from operations before working-capital changes” for the difference between a company’s accounting profits and its cash profits. If the former is way higher, it tells you that the company aggressively interprets accounting standards to dress up its reported profit. A widening wedge between cash flows from operations (after working capital changes) and net profits is a sign that the company’s high reported profit margins remain mostly on paper.

Related party deals

For renegade Indian promoters looking to siphon off capital, related party deals are often the preferred route. Companies are required to disclose all their related party deals with subsidiaries, associates, and enterprises influenced by key managers in detail in the balance-sheet annexures. Too many dealings between a company and individual managers on purchases, sales, services or royalty payments, are a pointer to capital leakages.

But you should be even more wary of unsecured loans and advances or inter-corporate deposits placed with unknown entities. These may simply be conduits for gratuitous payments to group firms in distress, or friends and relatives. These deals may even be reported as ordinary commercial transactions. Fortis Healthcare has recently been under fire, after its subsidiary loaned ₹473 crore to linked entities for ‘treasury purposes’.

Ricoh India, recently in the dock for falsifying accounts, had inflated its “IT services” revenues by 70 per cent through back-to-back sales and purchases from firms linked to its top executives. Even as it reported soaring revenues from the IT business, both receivables and unsecured loans shot through the roof.

Apart from financial statements, corporate behaviour too can act as an excellent early warning system on accounting chicanery. Inordinate delays in quarterly filings, auditors dragging their feet or sudden resignations by the CFO, the compliance officer or independent directors citing ‘personal reasons’ are often signs of a brewing fraud. Out-of-the-blue merger or demerger announcements often turn out to be last-minute Jugaad to paper over holes in the financials.

Finally, as an equity investor, you should be very wary of media-savvy managements who give out bullish growth projections and seem highly clued on to their stock price. Often, it is managements who pay scant attention to the market and talk very little, who turn out to be the best wealth-creators.

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