On the morning of 7 January 2009, Satyam Computer Services Ltd’s chief executive Ramalinga Raju confessed to fudging the company’s books to the tune of Rs7,136 crore over several years. The scrip fell almost 80% to close just short of the Rs40 mark that day.
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With evolving technology and flow of information becoming seamless, investors look at a firm’s financial statement before picking up the stock. But can a fraud be detected by reading the financial statement? “It will be difficult for a layman to detect anything if it is well done,” says Deepankar Sanwalka, head (forensic services), KPMG.
But it can be detected with some help from experts. With companies recently reporting their results for the quarter ended 31 December, this is a good time to understand what to look for in financial statements to evaluate a company. Here are five must-watch areas:
Whenever any entry in the balance sheet has an explanation attached, references to read the notes are given when the entry is made. These crucial bits of information are given at the end of the balance sheet.
“One should definitely read the footnotes; something that (unaware) investors ignore,” says Sanwalka.
The footnotes of a balance sheet mention all the items that might not have been introduced in the books.
Companies may try to make their books look better by keeping obligations (liabilities) off the balance sheet, but they generally do mention them in the footnotes.
“Read the footnotes for evidence that the company has ‘off-balance sheet liabilities’ or obligations that are not yet recorded on the balance sheet,” says Tom Robinson, managing director-education division, CFA Institute, US.
Contingent liability is one such item. “If the notes contain any contingent liability, immediately reduce it from the networth,” says Ashvin Parekh, national leader-global financial services, Ernst and Young.
The liability can be in the form of, say, any claim made by the suppliers, customers, excise department or service tax department. “Often some claims are not recognized by the company as they think they might not end up paying it. But at times these liabilities can completely wipe out profit made by the company,” says Harinderjit Singh, partner, Price Waterhouse.
“Cash flow is the most important thing to look for in a statement,” says Sanwalka. “Though the trend may differ for various sectors, say services or manufacturing, keep a watch on where the cash is coming from.”
If a company is reporting large amounts of net income or increasing net income while operating cash flow is negative or decreasing, more questions should be asked.
Check if loans are being used to run operations. If they are invested in long-term assets then it may not be a worry. But watch out for the yield. “If the gestation period of such investments is long, then check when will it start giving returns and the returns are justified or not,” says Singh.
Also, look at the cash levels of the firm. A healthy firm should have enough cash to pay for immediate needs and debtors.
What if the reported returns of one quarter are good, but those of previous quarters are not. Is the latest quarter a one-off case?
“Companies generally provide data for previous quarters as well. See whether there has been a consistent growth in networth and profit, especially networth. If there is an aberration, then dig deep to find out the reason,” says Parekh.
Also the financial statements would show if the company has consistently high levels of some key ratios such as price-earnings and debt-equity. Though it is not bad to have high levels of these ratios but it may be a problem in the long run. “The companies may be over-indulgent or overestimating, and it will crank up ultimately,” says Parekh.
It is also important to cross check the data of peers for the same periods to understand if the company is keeping abreast.
Look carefully for the revenue recognition policy and compare it with other companies in the same industry. If a company is reporting revenue sooner in the process than others, this would be considered to be aggressive, although still within guidelines. For example, one company might report revenue when products have been delivered to customers, while another may report when a contract is signed but before shipment. “Some companies do change their revenue recognition policy as it increases profit. Such policy boosts turnover on assets,” says Sanwalka.
Also look at how long it takes the company to collect from customers (called days of accounts receivable). If this number continually increases, it is a bad sign. “The company could be reporting fraudulent sales, may be aggressive at reporting sales or may be making sales to customers who cannot pay. It is a bad sign whatever the reason,” says Robinson.
Also look out for warning signals such as if operating cash flow is out of line with reported earnings, or if any non-operating or non-recurring income has been recognized as revenue. “Look out for exceptional items. They won’t happen again but boost the profit for that particular period,” says Singh.
Companies may resort to understatement of expenses to boost profit. This could involve deferring expenses by taking longer to depreciate buildings or equipment. It can be detected by comparing depreciation methods followed by other companies in the same industry. However, a “high depreciation is not always bad. Though it reduces revenue, but we know it will stabilize over time,” says Sanwalka.
“A company might also understate expenses by overstating the amount of inventory of goods (also known as stock) on its balance sheet. This can be detected by an increasing number of days worth of inventory in hand,” says Robinson.
Other warning signals could be classification of expenses or losses as extraordinary or non-recurring entry.
Also “companies at times make an expenditure and deflect it to subsidiary companies. They claim it as a loan, hence making it an asset in its book,” says Sanwalka.
One should always read balance sheet and cash flow statement in conjunction with the income statement. “Analyst reports can also be used as source of information,” says Sanwalka.
One can also use literature such as board of directors’ report, management analysis report and report on governance. “They can provide non-financial information crucial for the company. They can tell you about the promoters and their plans for the future, their internal style of functioning and many more such things,” says Singh.
Another aspect to consider is reading the audit report, which may have significant components that the investor should consider while evaluating a company. “Auditor provides an independent examination of the financials submitted by the management and this statement provides a credibility to the financials. The point, however, to consider is that whether this statement is qualified or not. A qualified report may indicate adverse functioning of the company as regards wrong application of accounting standards (revenue recognition or depreciation) causing overstatement of profits and assets,” says Singh.
Ask as many questions as possible on every transaction that you don’t find normal. If you are not satisfied with the answers but still plan to invest in that particular company, may be you need to think again.
Graphic by Uttam Sharma/Mint