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How To Check the Quality of a Company

how to check the quality of a company
How To Check the Quality of a Company
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This post is necessitated because of the recent controversies generated around PC Jewellers, Manpasand Beverages, Vakrangee, etc.

This checklist contains both qualitative and quantitative factors and if you apply it to any company, I’m reasonably sure you will be able to dissect any company’s innards and understand whether it makes for a sound investment.

FACTORREASONSWHERE TO FIND IT
QUALITATIVE
How many point of sales does the company have (dealers, shops, stockists, warehouses, etc.)?Some companies may create fictitious points of sales in order to either book higher expenses or funnel in cash as refundable deposits. There are 3 ways of checking this:

1. Management will discuss it in the AR

2. You can stealth call dealers and check

3. You also should divide sales by POS and check if there are variances year on year
Is the company expanding? Find out the reasons why. Are current capacities fully utilized?If the current capacities are semi-utilized, why should the company expand? (Unless the management is in a scammy mood)1. Directors' report/discussion i the AR.

2. In the cash flow statement in the Investments section.

3. By calling the company and checking with the CS about the reasons, in case the company is indeed expanding
How many years will the expansion take to make profits?(This is associated with the checkpoint above)This is not easy to gauge but considering that the company is already in the business, it should turn around a profit rather quickly. Nevertheless, you must dig around and check.
How many employees? What is the sale productivity per employee?This is one area where a heck of a lot of window dressing takes place. Fictitious employees are added to the rolls, assets such as computers etc., are purchased (in the books) and both capital and revenue expenses are booked.Divide the sales in the AR by the salaries to get the number of employees.

Now divide the sales by employees to check productivity,
How many unproductive or excessive assets in the company's fixed asset schedule?Companies that want to vacuum cash often buy unproductive or intangible assets. Therefore, your job as a researcher should be to check the quality of Fixed Assets.

The method of valuing Intangible assets should be checked as well,
In the Fixed Assets Schedule in the Annual Report.
How much are the contingent liabilities, and does the company have the cash to pay for these if the situation arises?Companies sue and get sued. Companies give guarantees that can be invoked. Companies get tax demands that they contest. And so on. Your job is to figure out the volume and quality of contingent liabilities and whether the company has sufficient cash reserves to meet these.In the AR.
Is the management technically qualified? Or, is the business managed by technically qualified professionals?The management must have technical expertise and experience in running the show. If they don't, they should appoint professionals.

If both the conditions are not met, then that's not a good sign.
You'll get the qualifications in the management profile where high salaries are justified 🙂
Any business risk from disruption?This is the biggest threat to every management. Computer got the typewriter out, email killed the small courier. Therefore it's always a good idea to figure out business wise. Falling sales, higher R&D expenses, commissions, credit periods extended to debtors, are tell tale signs a business is going through a rough patch,This information can be culled from the AR and by a GOOGLE industry research.
What is the history of credit worthiness?Has the company repaid loans in time? If not, why not? The reason can be genuine, or it can be - TROUBLE.You'll get this information from prior corporate announcements and from the AR.
What is the frequency of borrowing?A company that perpetually keeps borrowing may leave behind shareholders sorrowing. If this is the case, you must dig in to check how borrowed funds are spent.Current and prior ARs + old announcements.
Has the auditor qualified the report?If the qualifications are serious, it could spell big trouble for the stock price.Independent Auditors' Report in the AR.
Is there any change in accounting policies?This is an overlooked factor because no one pays attention to the policies. However, one minor change can add or deduct crores to/from the profits and therefore you must glance through these. The auditor also will mention the change in his report.In the AR
Have the auditors' resigned in the recent past?If yes, then this factor should set aarm bells rining and you should dig in more to check if the resignation was bonafide.In company's announcements and in old ARs.
QUANTITATIVE
Gross Profit MarginThis is often the most overlooked indicator that can lay bare the quality of the company.

Gross Profit margin is the margin that a company makes after it converts its raw material into finished goods. Now if peers are making 20% GP margin, it can be safe to assume that the company you are researching should make similar margins. If it doesn't something is wrong. It could mean that the operations are not efficiently managed or cash is being sucked out.
P & L account in the AR + peer comparison using apps such as Stock Axis or Stock Edge
Are the company's subsidiaries making profits or losses?Most companies own subsidiaries. The investment in such subsidiares figures under the Investments section on the Assets side of the Balance Sheet.

Now if the subsidiaries can either bleed or make money. It is your job to figure out whether the company's subsidiaries are losing or gaining
This information is available in the AR (consolidated accounts)
What % of sales and purchases to/from subsidiaries and group companies?Many companies window dress their accounts by pumping sales to their subsidiaries towards the close of the quarter or year.

The goods are later returned and the sales reversed.

If the company wants to show a lesser profits, then it will pump up purchases from subsidiaries and group companies.

It is your job to wade through the maze of related transactions.

Companies disclose this information in the Related Party Transactions in the AR.
What is the % of salaries paid to directors as compared to the net profits of the company?If your company is bleeding financially or making profits, will you reward yourself with a fat salary (unless you are VC funded)?

No you wouldn't. Therefore it is always important to check this parameter. If the percentage is high, then it can be assumed in 6/10 cases that the management just does not care about minority shareholders.
In the AR, in the related party transactions and in the salaries to directors information.
What is the % of Revaluation Reserves to Total Reserves?Revaluation reserves cannot be distributed. It is just a book entry that inflates the asset value on one side and the reserves on the other side. If bulk of the reserves are made up of revaluation reserves and the company has been in existence for a long time, and is not a turnaround case, look for another company.In the AR (Balance Sheet)
How much are the cumulative redeemable shares/debentures issued by the company?Cumulative debt instruments accumulate interest and when that hits the profits annually or as per terms, you won't know where the profits went.

Therefore check on how much of debt/referential shares are cumulative
In the Debt and Equity sections on the Liabilities side of the Balance Sheet.
How much inventory is held by the company as a % to sales?A company holds inventory in anticipation of orders. If the orders do not come through, the inventory keeps piling up.

If it keeps piling up year on year, it could mean that the finished goods in the inventory have gotten obsolete. Maybe the raw materials have expired their useful life.


Maybe that inventory is not actual inventory, but it represents just a book entry with subsidiaries.

Every industry has its quirks and therefore you must benchmark your company's inventory levels with its peers.
In the P & L A/C
What are the debtors to sales?Every company extends a credit period to its customers.

If the customers do not pay in time or default then the debtors pile up reducing profit margins.

If debtors increase and represent a significant percentage to sales, it means something is wrong.

Maybe the debtor have gone bad or maybe the sales are not actual sales, rather these represent a book entry with subsidiaries.

Every industry has its own credit period and therefore you must check the credit days based on the industry.
In the P & L A/C
Have any expenses been capitalized?

If expenses are capitalized
Are any expenses deferred?Deferred expenses are shown as an asset. If you come across a whole of deferred expenses, it should get your antenna up.In the Balance Sheet in the Other Current Assets
Any one time extraordinary gains or losses? Or any heavy fluctuations in Other Income?One time extraordinary gains and other income can help a company report profits or losses.

If you come across a one time profit or loss, you need to investigate that item.

As for Other Income, you have to check if the variation year on year is normal or extraordinary. A normal spike is fine, but anything unusual should trigger your investigative senses.
In the P & L A/C and in the notes to the accounts.
Are the cash flows from operations positive?A company that has been in existence for a long should ideally report positive cash flows from operations.

if it doesn't, it could be because of an one-off incident.

Otherwise there is no no justification for a company that has been existing since long to report a negative operational cash flow.
Cash Flow statement in the AR

Along with these notes, you also must initiate the following checks.

Remember, checking the quality of a company is a serious job and takes time and patience. Don’t be in a rush to judge too.

All the checks above and below will take at least 5-7 working days, so do not lose your cool.

CHECK IF THE ACCOUNTS ARE WINDOW DRESSED

MORE CREDIT RISK CHECKS

CHECK MANAGEMENT QUALITY

USE THIS FINANCIAL RISK CALCULATOR

4 Comments on "How To Check the Quality of a Company"

  1. Thanks sir! I will add this as a check list to understand about the company.

  2. How many times the company has gone for revaluation of its assets can also give some insight… Thx… Twitter..@WE4JAIN

  3. Good work sir

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