Last Updated on Jan 17, 2023 by
A stock is purchased based on primary factors like the fundamentals of a company, and when the company doesn’t report accurate financials, it is considered defrauding investors. Forensic checks are a saviour that can help an investor not become a victim of defrauding. There are a set of forensic checks, and we will discuss a few of them that one can follow to avoid fraudulent companies. In this article, let’s learn how to conduct forensic checks.
Set of forensic checks
1. High returns, where is the cash?
As there is a famous quote in the market, “Topline is vanity, the bottom line is sanity, and cash is the ultimate reality.” Many companies have higher profits and return ratios. But are these profits being converted to cash? This is a big question for investors.
Let’s take an example
| Particulars | Amount |
| Sales | 100 |
| Cost of goods sold (COGS) | Rs. 25 |
| Gross profits | 75 |
| Employee cost | 5 |
| Other Expenses | 10 |
| EBITDA | Rs. 60 |
This company is making an EBITDA of Rs. 60 at a sales of 100, taking an EBITDA margin of 60%. Looks so great and seems an interesting business model, but here is the catch, let’s say the cash flow from operation for this company is Rs. 20.
Now things look disconnected to an investor. How can a company which makes profits of Rs. 60 have cash of Rs. 20? That is why you should always check CFO (Cash Flow From Operating Activities)/EBITDA conversions, which should be at least 70%. Yes, now one can come up with some exceptional years, so you can do this analysis on a cumulative basis by taking cumulative CFO/cumulative EBITDA.
2. Debt trap
The debt trap is a situation where you are forced to over-consume loans to repay your existing debts. If your NFA turns (Revenue/Net Fixed Assets) is less than 1 for a prolonged period, you need to invest more than the turnover or revenue you make. This shows the capital intensity of a business. So after a certain point, dilution doesn’t remain an option, so companies need to raise debt, and as they want to grow more, they need to raise more and more capital to fuel the growth.
Let’s take an example.
| Particulars | FY 2022 | FY 2023 |
| Revenue | Rs. 100 | Rs. 200 |
| Net Fixed Asset | Rs. 110 | Rs. 220 |
| NFA turns | 0.91 | 0.91 |
If the company maintains the same NFA turns, it would require to double its assets to double its revenue. As the company does not have enough turnover, it needs to borrow capital and invest in the business.
3. Debt servicing
Usually, people see the debt to EBITDA ratio but looking at it from the perspective of cash makes more sense, so one should see debt to cash flow from operations.
Debt to cash flow from operations gives one an understanding if the company can meet debt obligations from the cash it generates. If this ratio is >1 for a long period, the company will find it tough to repay its debt and have to take new loans to meet the outstanding debts.
Net debt to EBITDA can also be a good measure for companies with non-core assets or cash on the balance sheet.
Net debt means long-term debt + short-term debt + current portion of long-term debt – cash – investments.
4. Taxation mischiefs
One should always check whether the taxes are going in cash. A better way to check is to compare cash tax to your peers’ PBT (Profit Before Tax). Sometimes companies might be in SEZ (Special Economic Zones) or maybe getting tax benefits from the government, so that also needs to be checked.
Deferred Tax Assets (DTA) and DTL is Deferred Tax Liabilities (DTL) – These items are created on the balance sheet because sometimes there are differences between accounting standards and the income tax departments.
Example:
| Particulars | Case 1 (Rs.) | Case 2 (Rs.) |
| Tax (According to accounting standards) | 100 | 120 |
| Tax (According to Income Tax departments) | 120 | 100 |
| Difference | -20 | 20 |
In case 1, the accounting standards state the tax should be Rs. 100, while the IT department says it should be Rs. 120. Here the Rs. 120 would be paid as tax, and Rs. 20 would be recorded as DTA.
In case 2, where the accounting standards state tax should be Rs. 120 and IT says it should be Rs. 100, the Rs. 20 goes into DTL.
If this DTA or DTL is continuously piling up on the balance sheet, it should be questioned, and if you see a write-off in DTA and it’s a huge portion of the balance sheet, it can be a red flag.
5. High sales growth due to high debtor growth
If someone is not able to meet their sales targets, they can make it more and more lucrative to buy a particular product. So when a company is growing, and its sales are constantly at a very high pace, one should question how it suddenly saw this massive growth.
A very lucrative way for a company is to extend the credit lines for higher sales growth. So one should become very cautious when these scenarios come up. One should always see the growth in revenues vis a vis growth in debtors.
| Particulars | FY 2021 | FY 2022 |
| Sales | Rs. 100 | Rs. 200 |
| Sales growth | – | 100% |
| Debtors | Rs. 40 | Rs. 100 |
| Debtors growth | – | 150% |
6. Where is the money going?
I had heard this somewhere “Promoters have one return target for themselves and another return target for minority shareholders.” Related party transactions might not always be illegal, but they surely show the intent of a company’s management.
Let’s understand how management has shortchanged (misled) minority shareholders.
There was the company ABC, which had been generating good cash profits. The founder and CEO owned 40% of the company. One fine year they lent this accumulated cash to an entity the CEO’s son owned, and the entity was not getting loans from any banks due to their lack of credibility. After a year, this loan was considered as bad and was written off.
Now the point is that the cash profits lent originally belonged to both the CEO and the shareholders. By doing this, shareholders were prone to losses due to the loan being written off. Now one might argue that the CEO of company ABC had also faced losses, but the CEO gave loans to the related parties (in this case, his son), so directly or indirectly, the money came into his pockets.
In such a case, one should check the interest charged and whether the interest is even coming in cash.
Another aspect which needs to be checked while doing this analysis is contingent liabilities. Sometimes promoters don’t lend money but give guarantees on loans, and that too on the company’s behalf; this guarantee means if the person given the loan defaults, the company pays his loans off.
Sometimes promoters of some companies have their entities and sell them to the listed company.
For example, Asha Tyres is a company where promoters own 25% of the company, and the promoter owns 100% of a company named Isha rubbers. So the promoter sells their entity Isha Rubbers, to the listed company, Asha Tyres, at a euphoric price. This would again be cheating the minority shareholders. It could be vice versa, where the promoter buys out some other subsidiary of Asha Tyres at a dirt-cheap valuation.
These are just some ways where promoters can mislead investors by transacting through related party transactions. You should always be cautious and check RPT (related-party transaction) disclosures. You should also check how much percentage of purchases or sales is done by related parties.
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