How To Audit Management Quality of a Listed BSE-NSE Stock

A high quality management can take a company to great heights while a low quality and irresponsible management can wreck a cash rich conglomerate in no time.

Therefore, as an investor, you must analyze management quality before making a buy.

Initially I was to write this by taking a company as an example, but my lawyer buddy says that can get me in trouble. So here are some of the ricks I use to figure out management quality.

The only tool you need is the latest Annual Report. This is how you should audit management quality.

A. Directors’ Quality

Assume the name of the first director is “John Doe.”

Perform any or all of the following searches on Google.

“John Doe” + scam
“John Doe” + politics
“John Doe” + court case
“John Doe” + cheating

plus, you can search for “John Doe” in the “NEWS” section on Google.

You can do this with or without the quotation marks. You can use other keywords as well.

You have to perform this search for all the directors. If there’s any negative news for any person on the board, Google will unearth it for your reading pleasure.

B. Subsidiaries, Associates and Transactions With Them

Many companies set up a whole lot of subsidiaries and engage in sell and purchase transactions with them. Genuine companies that mean well do engage in transactions with subsidiaries and associate firms, but these are with good intentions. On the other extreme, shell companies make up most of their sales and purchases from transactions with their subsidiaries. Then there are some companies that lie somewhere in the middle.

Let me give you an example, Company A sells to its subsidiary, Company B, at the end of a quarter. The subsidiary returns the goods in the next quarter and the sale is reversed. What happens is that the investor and analysts get taken for a ride because of the inflated numbers.

Therefore while analyzing management quality, you must examine the transactions with subsidiaries and associate firms. Look for the following flags.

1. Sales and purchases to/from such companies (are these substantial or even significant when compared to the full year’s figures?)

2. Rents or consultancy charges paid to promoter. (are these charges being paid despite the company making losses? or how much % of profits are eaten away by such transactions).

If you come across such payments and if these payments are over the normal course of business, then it reflects poorly on the management because it implies diversion of profits from the parent company.

This information can be sourced from the Directors’ Report.

C. Directors’ Salaries

If any owner-promoter is drawing a large salary when his company is reporting cash losses, then it is a bad sign. Or, if a promoter-director draws a large salary that seems abnormal when you compare it to the profits, then that too is a sign of low management quality.

There can be a few example, as in the case of pharma or software companies wherein money is pumped into development/discovery of products. In such cases, high salaries are justified.

This information can be sourced from the Directors’ Report.

D. Qualifications in the Auditor’s Report

Though it is boring to read through an audit report, you must go through it to learn if the auditor has a negative view. I’ll give you an example of a publicly reported case – Religare. Whatever company you invest in, you must read the internal, secretarial and statutory auditors’ reports that are contained in the annual report.

The report will help you understand how the management has sugar coated the accounts by either not providing for expenses or by following fancy accounting policies or by not maintaining statutory books. For example, not providing for interest because the company is in CDR, books destroyed in fire or lost, because of which auditors could not verify the true state of affairs, etc.

E. Operational Cash Flows

Any decently managed company generates positive operational cash flows, which it either retains or uses to pay off debt or invest in new businesses. If a running business, unless it is capital-intensive and needs some years to stabilize, cannot generate adequate positive cash flows then there’s something wrong with the management.

I can also add notes on Corporate Governance, but every management constitutes enough and more committees, at least on paper. that meet the requirements of the Company’s Act, and therefore I will not go there.

These 5 factors will help you analyze management quality and make an informed decision. Good luck.