With the court sentencing Ramalinga Raju seven years of rigorous imprisonment for perpetrating financial fraud, India's largest corporate scandal witnessed a closure of sorts. However, if a report by ratings agency India Ratings is to go by there are many more Satyam's mushrooming in India Inc.
As per the report, one third of India's top 500 companies are managing/window dressing their accounts. To everyone's surprise the percentage of black sheep's in BSE 100 list is in excess of 15%! Imagine financial statements which are the essence for making investing decisions are being fudged by corporates at will to show a rosy picture. This raises a big question over the health of financial reporting quality in India Inc.
However, the bigger question is what are the auditors and ratings agencies who are assigned the job to bring such issues to light doing about it? If corporates are able to modify financials in such a large scale it is an indirect failure of audit firms who are verifying the numbers. This also raises question on the objectivity of having independent directors on board.
Knowing that camouflaging is recurrent and intermediaries are not doing enough what should investors do in order to identify such mischievous companies?
Well, one strategy is to focus on the cash flow metrics. It is easy to manipulate earnings but not cash flows. As an example, a company by employing aggressive revenue recognition technique can boost its revenues. However, if a glance at the cash flow statement reflects continuous build up in debtors it is a sign of red flag. Inability to liquidate debtors and collect money is a sign that the revenues were booked beforehand to build a rosy picture.
Rising instances of earnings manipulation makes investing based purely on financial strength a dangerous approach. It indicates why meeting management is such a critical aspect to investing. Not that by meeting management you would get to know of earnings manipulation. However, a conversation helps one understand the mindset and thought process of the management. It also gives subtle hints as to how management thinks and acts. This is one area where we at Equitymaster pay utmost importance.
Let us highlight an instance we encountered recently to help you understand why a meeting exercise is so important to us. We wrote about it in a recent edition of The 5 Minute Premium sometime back. However, we would like to share it again as the occasion is apt.
It is not that the company we met managed earnings or tried to create a rosy picture. It is just that the facts that it stated made us ponder a bit and so we decided to take steps to validate them. Since the company was into manufacturing stainless steel (SS) pumps it highlighted various benefits that these pumps had. Few of them were substantial power savings, durability, higher output etc.
We thought of doing some market research in order to confirm the figures given to us as they appeared quite optimistic. We were lucky enough to get through a couple of vendors who were ready to speak to us on this matter. And to our surprise most of the claims made by the SS pump manufacturer were refuted by the vendors that we spoke to.
So, now we had two conflicting opinions in place and we did not knew who was right or wrong.
In fact, to be honest, our aim in conducting this exercise was not to know who is right or wrong as we knew both parties would have good things to say about their products and knowing their true intentions would be difficult. But the whole idea was to get an outside view that would help us think a bit more about the business and its dynamics. This would not have been possible if we had solely relied on financials and recommended the company outright.
The bottom line is that investing based solely on financials is tricky considering the quality of financials of India Inc are below par. What is further discomforting is the inability of mediators (auditors, board members) to bring this to light. Hence, one should always assess the quality of management before making any investment decision. And not go solely by the reported financials. Wherever you find that the quality of cash flows and the management do not seem comforting from long term perspective, it would be better to throw out such poison stocks from your portfolio at the earliest.
As per the report, one third of India's top 500 companies are managing/window dressing their accounts. To everyone's surprise the percentage of black sheep's in BSE 100 list is in excess of 15%! Imagine financial statements which are the essence for making investing decisions are being fudged by corporates at will to show a rosy picture. This raises a big question over the health of financial reporting quality in India Inc.
However, the bigger question is what are the auditors and ratings agencies who are assigned the job to bring such issues to light doing about it? If corporates are able to modify financials in such a large scale it is an indirect failure of audit firms who are verifying the numbers. This also raises question on the objectivity of having independent directors on board.
Knowing that camouflaging is recurrent and intermediaries are not doing enough what should investors do in order to identify such mischievous companies?
Well, one strategy is to focus on the cash flow metrics. It is easy to manipulate earnings but not cash flows. As an example, a company by employing aggressive revenue recognition technique can boost its revenues. However, if a glance at the cash flow statement reflects continuous build up in debtors it is a sign of red flag. Inability to liquidate debtors and collect money is a sign that the revenues were booked beforehand to build a rosy picture.
Rising instances of earnings manipulation makes investing based purely on financial strength a dangerous approach. It indicates why meeting management is such a critical aspect to investing. Not that by meeting management you would get to know of earnings manipulation. However, a conversation helps one understand the mindset and thought process of the management. It also gives subtle hints as to how management thinks and acts. This is one area where we at Equitymaster pay utmost importance.
Let us highlight an instance we encountered recently to help you understand why a meeting exercise is so important to us. We wrote about it in a recent edition of The 5 Minute Premium sometime back. However, we would like to share it again as the occasion is apt.
It is not that the company we met managed earnings or tried to create a rosy picture. It is just that the facts that it stated made us ponder a bit and so we decided to take steps to validate them. Since the company was into manufacturing stainless steel (SS) pumps it highlighted various benefits that these pumps had. Few of them were substantial power savings, durability, higher output etc.
We thought of doing some market research in order to confirm the figures given to us as they appeared quite optimistic. We were lucky enough to get through a couple of vendors who were ready to speak to us on this matter. And to our surprise most of the claims made by the SS pump manufacturer were refuted by the vendors that we spoke to.
So, now we had two conflicting opinions in place and we did not knew who was right or wrong.
In fact, to be honest, our aim in conducting this exercise was not to know who is right or wrong as we knew both parties would have good things to say about their products and knowing their true intentions would be difficult. But the whole idea was to get an outside view that would help us think a bit more about the business and its dynamics. This would not have been possible if we had solely relied on financials and recommended the company outright.
The bottom line is that investing based solely on financials is tricky considering the quality of financials of India Inc are below par. What is further discomforting is the inability of mediators (auditors, board members) to bring this to light. Hence, one should always assess the quality of management before making any investment decision. And not go solely by the reported financials. Wherever you find that the quality of cash flows and the management do not seem comforting from long term perspective, it would be better to throw out such poison stocks from your portfolio at the earliest.
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