As an investor, you have access to the audited annual reports, unaudited quarterly reports and audited semi-annual reports. Do not take accounting numbers on the face of it. There are various methods management may employ to deceit investors. It will all look good until it all comes out, and by that time, it’s usually quite late.
There are many books written on this subject. I have particularly liked all the editions of “Financial Shenanigans: How to Detect Accounting Gimmicks & Frauds in Financial Reports” by Howard M. Schilit and Jeremy Perler. You have to read the annual report like a detective and see the gaps. Often you may sense something wrong than a piece of conclusive evidence. Nevertheless, it is a good enough reason to move to the next company.
How to smell cooked books:
Cumulative CFO falling short of incremental net profit
If management inflates the company’s revenue, the chances are that the revenue may never come to the company, hence not show up in cash from operations (CFO). This will lead to CFO lagging net profit. Add CFO for the last ten years and compare the past ten years of cumulative net profit. If you smell something, run away!
Change in DSO
DSO = Accounts Receivable / Sales X 360
A fake revenue would lead to accounts build-up and a rise in DSO. Similarly, watch drop in DSO, which may be linked to a receivable selloff.
Change in DIO
DIO = Inventory / COGS X 360
Inventory build-up may be due to the company not selling and management unwillingness to write off. A sudden write off should be seen with suspicion since that will lead to a decline in DIO.
Free Cash Flow
Look for companies that have a positive Cash Flow from Operations (CFO). CFO that requires enormous investment may not lead to value creation.
FCF = CFO – Capex
M&A
A lot of companies want to grow inorganically. There is no issue with that, but often, that may lead to muddy waters. Look at old acquisitions and find out the value creation over five years, ten years etc. Also, be wary of the price paid for the acquisition.
CFO - Capex outflow - Cash paid for acquisitions
Changes in the accounting policies
Be careful when the company adopts aggressive accounting techniques. Be highly sceptical when the auditor resigns.
One indicator that will always work is when you ask management for clarification, they don’t answer. There may be genuine reasons for not sharing on an analyst call, but management's effort would be providing some lead or help rather than duck the question. I listen to analyst calls just to get a sense of the management’s tone.
Additionally, growth in auditor’s compensation, the ratio of capital work in progress and gross plant property and equipment, contingent liabilities to assets, bad debt provisions to receivables etc., may be other areas that may indicate management’s chicanery.
Disclaimers
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Details of the advisor
Advisor: Ankur Kapur
SEBI RIA No.: INA100001406
BASL Member ID: BASL1337