Amid a raging bull market, forensic accounting expert Ashwini Damani offers tips on how to spot red flags

Ashwini Damani, senior analyst at the family office of a prominent corporate house.

The current bull market is causing many new stock market investors to think that they have become experts at spotting multi baggers. What they don’t realise, and probably will, much later, is that rising stock prices are not always a reflection of sound fundamentals. And what you see in the balance sheet is not always what you get. Ashwini Damani, senior analyst at the family office of a prominent corporate house, and a chartered accountant by training, specialises in forensic auditing. In an interview with Moneycontrol, Damani spoke about the accounting red flags that investors should keep an eye out for.

Edited excerpts from the interview:

How did you get interested in forensic accounting?

Initially that was not my area of interest. Because I spent around 10-12 years in financial reporting and audit, and had gone through hundreds of financial statements, I was able to quickly spot when some balance ratios didn’t make sense.

What was the incident that got you started?

One of the firms that I was auditing had to pay a bribe to a politician. Since an expense of this nature cannot be officially disclosed, it would have to be hidden somewhere in the balance sheet. The basic principle of accounting is that for every debit, there is a credit. If you try to hide a profit or an expense, another part of the balance sheet will automatically bloat. It struck me that many companies would be doing similar things, and by focussing on ratios that did not make sense, one could get an idea if the account books were being cooked.

Which was the first stock where you sensed that something was wrong with the numbers?

Opto Circuits. Firstly, the ratios were not making sense. As a chartered accountant, I was trained to observe the cash flows and not merely the profit and loss (P&L) statement. Making an entry into the P&L doesn't finish the loop, you need to tie it up to the cash flow statement I noticed the absence of cash flow from operating activities and the tax payments seemed bogus. It soon became evident that the management was just shuffling money around. Focussing on the tax actually paid and not provisions for tax, these are simple things, but most investors overlook it.

How did you apply some of the lessons that you learnt as a financial auditor?

For my own investments. I got a kick being able to spot issues in balance sheets and observing how they unfolded over the following years.  I then joined Value Picker, a forum for value investors where people discussed investment ideas. The principles of financial statement analysis that I had developed for my personal investments came in handy for evaluating potential investments discussed on the forum. The more financial statements I looked at, the better was my ability at being able to spot patterns.

What was the experience like?

Generally good, but there was this company, which I cannot name, where the promoter was running a privately held firm of a similar nature as the listed entity. Every time he wanted to get the market cap up, he would transfer sales from the private entity to the listed one. I was so convinced of being right in my assessment of the company that I could not spot the fraud when it was happening right in front of my eyes. I lost a packet in that stock.

What are the key numbers that you seek out as soon as you dive into a balance sheet?

Return on Equity (RoE), cash flow conversion (ability of a company to convert operating profits into ree cash flow), and balance sheet size. If the total on the asset side adds up to say Rs 50,000 crore, you need to check the number against each of the line items like plant and machinery, working capital etc and see if they make sense. For instance, in the case of a mid-sized retail store chain, I could see that the amount spent on air conditioners was inflated when comparted with the number of stores in operation.

Then there are some obvious red flags. Like a jewellery company should not have debtor days, because they don’t sell on credit. A media and entertainment company should not have receivables of more than 60-70 days…

Why so?

If you are an exhibitor, then the industry works on a weekly payment cycle. Check with peer group companies and see what their receivables are like. In fact, the thumb rule is to compare with peers and see the variation. If it is too much, you need to ask: why?

Can you elaborate on the cash flow conversion?

I believe that on a long on a five to seven year basis if you just add up the operating profits of the company 60 to 70 percent at least should translate into cash flow from operations. I say 60-70 percent because you need to put some more money into debtors and inventory as you keep growing. There is always a timing gap, you may sell something in March and it may get recovered in April. I don’t look at individual years, because things can go wrong once in a while. Also, it will vary across industries. For an EPC (engineering, procurement, construction) firm it could be closer to 60 percent and for an IT company it could be closer to 90 percent. Check how peer group companies are doing. If enough of the operating profits are not getting converting into cash flows, then you need to doubt the operating profits.

Which are common ways in which managements try to mislead shareholders?

The most common method is to inflate profits, and when you do that, you also have to inflate reserves and surpluses, which is the liability side. That means you have to inflate the asset side as well. Overpaid acquisition is a good way to do that, as it bloats up your goodwill. Check if the company being acquired is in any way a related firm.

How does one do that?

The company must mention that, and if they fail to do that, there are sites like Zauba and Tofler that allow you to make a family tree and check if there are any common links. Sometimes there are obvious telltale signs. Like the company that was acquired for a hefty sum may not even have a functional website.

Earlier, fake receivables was a common place for inflating profits, but because of GST (good and services tax) that has become difficult. Auditors can easily corelate GST data with the receivables and check for genuineness.

Which are the other areas?

Loans and advances to group companies or third parties. Then there is inventory, which can get a bit tricky. Sometimes it is obvious that the company is fudging numbers. Like a diary company having an inventory of 200-300 days. But how do you know if the diamonds held by a jewellery company is actually worth the crores that the management claims it is. Capex bills can be inflated. There is no way an auditor can check each and every bill.

From a retail investors' perspective which are the easier red flags to spot?

Watch RoE. A low RoE could be a sign that the asset side is bloated. When I see a supressed RoE, I try to figure out if it is due to an industry downcycle or an inflated balance sheet. Using the Dupont formula—margin multiplied by leverage multiplied by return on assets—gives an idea. Comparing margins across the industry is crucial. If an industry leader earns, say a 7 percent margin, a similar business should aim for 7-10 percent. Examining leverage over a 5-7 year period reveals notable differences from industry peers. If RoE significantly varies, particularly in fixed assets, it points to an inflated balance sheet.

A prolonged CWIP (capital work in progress) is another warning sign. That could mean either the company is not getting the requisite approvals for the plant or that the capex has been overstated.

A company where CWIP keeps going up regularly without getting translated into fixed assets or without getting translated into higher sales, then you should ask the management why they are spending money on building an asset which a) is not getting completed or b) is not translating into higher sales. If the management is unable to adhere to a deadline repeatedly, it means the numbers are being faked.

Thirdly, watch for write-offs and write-downs. They are usually the result of aggressive accounting practices in the past. If a company does that often, it means you can’t take the numbers at face value.

Do you always go for the perfect balance sheet? Or do you say I am fine with the imperfections in the balance sheet up to a certain threshold?

When I when I look at the financial statements it is not always with the intention of finding a fraud. I just need to be aware that there is a problem in the balance sheet. Sometimes managements try to delay recognition of certain accounting items because they are under pressure from the investing community, or just trying to save their jobs. When the actual event happens, the market punishes the stock and that may actually be a buying opportunity because you know this was coming.

We are seeing a massive run up in shares of small and micro-cap companies which are announcing huge order wins. On paper, it appears the companies’ earnings will soar in the days ahead. What should investors be keeping an eye out for?

These are companies typically work on percentage of completion accounting. You get paid for the quantum of work you have completed. Watch for the unbilled revenues as a percentage of sales. (Unbilled revenue is revenue a business hasn’t billed its customers for, though it has delivered the promised goods or services). If this number keeps going up, then there is a problem.

Lay investors won’t be able to spot the red flags as well as qualified professionals like you. So what is your advice to them?

If you are putting your hard-earned money, you better learn the basic rules of the game. Today, there is plenty of free tools to compare the key ratios and also enough content available on the net to be able to understand the concepts. If you cannot take the trouble to do that, you are better off entrusting your money to professional fund managers.