Classroom | Red flags in financial statements; scheme of arrangement, working capital, cash (Equity : Part 25)

In the previous chapter on accounting red flags, we explained what prospective investors should be looking for in a company’s income, expenses and interest statements. In this chapter, we highlight the things to watch out for in the scheme of arrangement, working capital and cash in the company’s books.

Schemes of arrangement: A lay investor may find this a very difficult document to read, but it’s one of the most important ones. This is where many companies get away with doubtful accounting practices and wash away some of their sins. Since this is a court-supervised process, sometimes the standard accounting norms may not be mandatory and once the court approves the scheme, it gets implemented. For instance, there are times when companies have used this to directly adjust the amount of goodwill against the reserves. Normally, this would have been expensed every year and it would have lowered the profit.

Working capital: At your kirana store, you may have noticed a company's salesperson trying to persuade the owner to stock a new product. The owner might be hesitant, and the salesperson will ask the shopkeeper to keep it and pay him back only if the product sells. That’s selling on credit.

An increase in revenue should normally see working capital also change accordingly. If sales have not increased much, but debtors shows a sharp increase, or if creditors fall sharply, then you should be on alert. It could be normal, maybe the company is giving more credit period and earning better margins, or business is slow. Similarly, a fall in creditors could be because they are offering discounts in turn. So look for reasons, see how peers are performing, and if it’s not adding up, be careful. Companies disclose debtors up to six months and those above, if there are any unusual movements or write-offs that could be a red flag. Even if there is no unusual movement, a very high level of debtors, especially in the more than six months category is a red flag. Watch for unusual changes in debtor days, inventory days, or creditor days.

Cash: The cash levels—both in the bank and in liquid investments—should move in tandem with how the business is moving. The working capital factor is linked here. If a business is growing but the cash and investments are not reflecting accruals, then that’s a worrying sign. But it’s common to extend more credit in order to grow a business, so do see if that’s the reason for the discrepancy.