How To See Through Financial Window Dressing

how to figure out a financial scam

A researcher can easily discover financial jugglery by analyzing relationships from financial data.  Wild, unexpected or exaggerated fluctuations in these relationships point out that something is either unexplained or wrong.

One off or unusual transactions often create fluctuations in financial relationships between different items, and help the researcher figure out fraud.

Let’s get down to what you must analyze:

Assets to Liabilities Ratio

When a company starts operations, it usually starts with the promoters contributing to equity. Then it also takes a loan to meet its long or short term commitments, and with the money in hand, it buys assets and starts operations.

Over time, it starts making profits and building on its assets (either physical or liquid) and after some years it is naturally expected that its assets will far exceed its liabilities.

Let’s take an Example of Hikal Ltd., as on 31-3-17.

The equity is 16.44 crores, reserves are 605 crores, non-current and current liabilities work up to 746 crores. Of these liabilities, only the 746 crores are payable.

The total assets (fixed, current) work up to 1367 crores.

Therefore 1367/746 = 1.83, implying that assets comfortably exceed liabilities.

This is the first check you must perform. Remember that if this year’s assets-to-liability ratio shows a heavy fluctuation over last year’s it implies something is wrong.

For example, if prior year’s assets-to-liabilities ratio was 0.50 and if this year’s ratio is 0.75, it implies

a. Company is financing business by borrowing and does not have sufficient equity (bad sign)

b. Liabilities were reduced by generating operational cash flows or equity, or additional assets were bought by raising equity. If there is no valid explanation for this wild fluctuation, it implies something is wrong or the management is hiding something.

Relationship Between Sales, Debtors and Inventories

Some companies who want to jack up their stock prices or entice lenders/investors, often sell their products to their group companies or their friend’s companies.

Here’s what happens:

  1. Goods are sold on credit to known parties.
  2. This jacks up sales and debtors.
  3. The payment is not made and the goods are returned in the next accounting period.
  4. The lenders and shareholders get taken in by the increased sales and it is possible tat many act impulsively.

To understand if a financial scam is going on, here’s what you should compare:

a. DEBTORS TO SALES:

Let us understand this ration by citing an example:

If sales were 1,00,000 last year and debtors worked up to 10,000, it implied that debtors were 10% of sales and the company sold Rs 8,333 on an average per month.

This implies the company offers a credit period of maximum 35-40 days to its debtors.

Now, if in the current year, sales rise to 1,50,000 and debtors jump to 30,000, it implies that the debtors to sales percentage have increased from 10% to 20%.

Let us check the credit period now. If the company sold 1,50,000 per year, then it sold 12,500 per month.

The debtors jumped to 30,000, implying the credit period jumped to about 72 days. We have a jump in credit period of more than a month (from 35-40 days to 72 days) and a doubling of the percentage growth in debtors. This requires investigation and it is likely you will unearth something fishy.

b. INVENTORIES TO SALES:

The ratio compares the inventories held by the company to the sales. To understand it, let’s take an example:

If sales were 1,00,000 last year and inventories worked up to 15,000, it implied that inventories were 15% of sales and assuming the company sold Rs 8,333 on an average per month.

Note that inventories are valued at cost, and therefore assuming a GP margin of 20%, let us say that the market value of inventories is 18,000. The adjusted inventories to sales percentage is 18%.

These numbers imply that the company carries inventories for a  maximum 66 days (18000/8333).

Now, if in the current year, sales rise to 1,50,000 and inventories jump to 30,000 (market value 36,000), it implies that the inventories to sales percentage has increased from 18% to 24% (adjusted) (36000/150000).

It also implies that the inventory holding period also has jumped to about 85 days (36000/12500).

So the inventory holding percentage has jumped from 18% to 24% and the inventory holding days from 66 to 85.

Now, excess inventories and debtors can also result because of a recession or government policy (demonetization, GST), and if these are not the cause then the increase in inventory holding implies that either the product is outdated (technological obsolescence, or past expiry date) and may be therefore unsaleable.

These checks will help you unearth some red flags that can be because of financial jugglery.

Quick Ratio

Though this ratio is a simple calculation, it can help you figure out financial window dressing.

Quick Ratio divides the liquid assets (debtors, cash, investments, loans) with current liabilities (which can be made payable on demand).

QR = Debtors + Cash + Investments/Current Liabilities

Let’s take an example:

If a company’s quick ratio is 3 in the past year and 1.5 in the current year, it implies that either the numerator has decreased and/or the denominator has increased.

So if the numerator has decreased, it implies debtors, investments and cash balances have reduced. This could be because of bad debts or a downtrend in the economy or because of excessive competitive pressure. The decline needs to be investigated.

If the numerator has increased, the cash flows should also increase in tandem. If not, then it is possible that some window dressing is going on.

If the denominator has increased, it means current liabilities (mainly made up of trade payables) have ballooned. Has the production increased? If the production has increased, the sales should increase? If not, why not? Once you get into the current liabilities you should correlate it with sales, cost of production, inventories and try to figure out why the company obtained more stocks on credit.

If the denominator has decreased, it could mean that the company is not getting orders and has therefore stopped buying material. It could imply obsolescence of the product line. Or it could mean that the company used up a lot of its cash flows in paying off trade payables. This too must be investigated because it is possible the company bought from a group firm and was in a hurry to pay it off so that some cash was exchanged with the promoters.

Net Profit Margins

When the Net Profit (before tax) is expressed as a percentage of sales, it shows how efficient the company in the line of business.

Let us take a common businessman’s example: If he makes 1,00,000 profits on sales of 8,00,000 and pays no tax, it implies his net profit margin is 12.5%. Naturally, every person wants to grow his income and therefore this businessman will try to increase his sales and net profit margin going forward. The same should be expected from a company.

So, how does the net profit margins uncover a financial scam?

Let’s take an example:

Year 1:

Sales: 1,00,000
Total Expenses: 80,000
Net profit: 20,000
Net profit margin: 20%

Year 2:

Sales: 1,50,000
Total Expenses: 1,35,000
Net profit: 15,000
Net profit margin: 1o%

In the example above, revenue increased 50%, but cost increased 54% pulling down the net profit margins from 20% to 10%.

What could be the reasons for the increase in the expenses?:

a. Are expenses (sales, raw materials) overstated?

b. Have any new and unusual expenses been incurred?

c. (In case net profit margin has abnormally increased) Are sales overstated, or expenses understated?

Debt and Interest Cover Ratios

Think about it – if your own about 1 crore worth of assets, how much would you borrow to set up a business?

You’d ensure that you’d borrow up to a maximum of Rs 1 crore so as to ensure you can pay up the interest and repay the loan in case your business goes bust. But no more.

The same applies to companies. If the companies equity is 1 crore then the best case scenario is that it has no debt, a good case if it’s debt is 50% of equity, an okay case if the debt is 100% of equity. Things start getting worse after the debt crosses 200% of equity. Look what happened to Rcom, JP Associates, Bhushan Steel, etc., when they chose to borrow more than could afford.

You can check debt: equity ratio by dividing Debt by (Equity+Reserves).

The Interest cover is extremely important as well. Banking norms require companies to maintain the EBITDA/Interest cover at a minimum of 2.0. That means a company’s earnings before interest, depreciation and taxes should be at least 2 times the interest it pays on loans. Anything less than that is a red flag.

Sometimes promoters obtain loans and divert it for their personal use or spend it it on non-revenue items and these ratios catch the tiger by its tail.

Sales Growth

Every company grows over time. Typically for a good company, sales growth  easily exceeds the inflation rate. But the growth is more or less consistent unless there’s a major disruption such as global shortage of product leading to massive price spikes (HEG, Graphite), production facilities shutting down across the world, etc. When events like these occur, sales growth spikes abnormally.

On the flipside, negative disruptions such as demonetization and a flawed tax structure (GST) can make growth fall dramatically.

Point is that besides disruptions, there is little else to impact sales growth.

Now, companies that are desirous of showing higher sales growth for whatever reason above the normal, often resort to financial jugglery.

You should check the year-on-year sales growth of any company and if you find any abnormal spike that is unexplained, you should start digging deeper (which you can catch using the techniques above).

Besides these techniques, BullBull wwill publish a tool that will help you determine the risk profile of any company. Stay tuned for that.

6 Comments on "How To See Through Financial Window Dressing"

  1. Great article

  2. well explained

  3. Beautiful explanation Sir…i am highly benefitted from this knowledge shared…appreciate your time invested to help out novice minds in the financial world …

  4. Manish Chaudhary | May 20, 2018 at 5:32 pm | Reply

    Sir, Thanks for the wonderful article. Could you suggest me the best website to refer for companies data like above?

  5. Nicely explained… well taught

  6. I always knew the ratios but never really understood their signifiance and ability to detect fraud in companies.

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