Thread by @soicfinance

Thread on How to do Forensic Analysis of a Company 📚💵🧮

In this thread we will talk about:
1⃣ Why Forensic Analysis is important
2⃣ How sales can be manipulated
3⃣ How companies rigged cash flow
4⃣ Importance of related party transactions

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Warren Buffett in his letter said, "Beware of companies displaying weak accounting. When mgt takes the low road in aspects that are visible, it is likely they are following a similar path behind the scenes."

We will discuss how to find weak accounting practices by companies.

Net Profit is one of the most important parameters looked at by the investors, as it forms part of various important ratios used by investors to do the valuations of a company like PE ratio.

All the companies make their best attempt to generate profits as high as possible.

Sometimes to show good profits in a year companies manipulate their books of accounts. As investors expect profit growth from companies they own, bad results result in share price going down.

To manipulate the P&L companies may inflate the revenues.

Revenue can be rigged by various means:

Channel Stuffing: It is the practice of sending more goods to distributors and dealers than they currently need.

Companies engage in this to artificially boost its sales and profit levels, thereby deceiving anyone reading its financials

With some of the scuttlebutt we got to know that in the last few months one of the leading paint company has done the channel stuffing during quarter end in which they sent the materials to dealers on interest free credit for a few days. 🎨🖌️

Increasing % of traded goods:

High % of revenue from trading activities for companies is a red flag as it is a poor quality of revenue as it can be rigged easily

This can be done to artificially inflate the revenue as asset turns in trading are high but margins are very low.

High % of Receivables:

We should always look at receivables as % of sales. To inflate profits companies may do bogus sales on credit & it is outstanding in receivables.

Give more emphasis on receivables outstanding for more than 180 days and check the provision on receivables

Also check the % increase in sales as compared to % increase in receivables.

There could be some genuine reason for high % of receivables but one always needs to be sceptical to get the clear understanding.

A pharma co has done sales of 402 cr in 2017 which has increased to 1269 cr in 2022 i.e, 3.16x jump in 5 years but its receivables has increased from 33 cr in 2017 to 320 cr in 2022 i.e, almost 10x jump in 5 years.

Mgt mentioned this is due to change in business mix.

However, on these 320 cr receivables and otherwise also in the last 5 yrs the company hasn't created any provisions on trade receivables.

Surprisingly they don't have even a single rupee of bad debt in the last 5 yrs 🤔🤔

One-off adjustments in revenue:

While analysing financials of a company we should remove the one-off adj in our calculations. These could be one time gain or loss due to contract termination fees, loss due to fire, insurance claim, etc.

A chemical company in FY22 has received a contract termination fee of Rs. 631 cr; normally these should be recorded in other income but they have recorded it under revenue so its revenue from operation has gone 🆙.

Some say as per Ind AS they have to record it under revenue.

Then we checked the investor presentation of the company.

There also co did all ratio and financial growth analysis including one time income as revenue which again makes us sceptical. 🚨🚨

CFO/EBITDA Ratio:

We should check the cash flow generated from operations as compared to operating profits of the company i.e. EBITDA

EBITDA is calculated as Sales -COGS -Employee Cost -Other Exp

Few cos include other income into EBITDA which is not good accounting practice

If companies are not able to convert its EBITDA into cash on medium to long term basis then one should not invest in such companies.

As cash is always the King 👑

The ideal CFO/EBITDA ratio is 60% for B2B companies and 70% for B2C companies.

One such company where cash conversion became poor was a pharma company which started seeing headwinds in its core business due to increasing competitive intensity and margins gone for a toss.

In H1-FY22 company reported 8% growth⏫ in revenue and 11% de-growth in EBITDA ⏬.

When we checked the cash flow of the company it was very poor as:

CFO became negative 🚨🚨
Changes in Inventory & trade receivables gone up multifold 🏮🏮🏮

In H2-FY22 the company reported huge losses; share price is down by more than 60% from the date of the H1 results.

Now since we saw how cash flow is important especially CFO, some companies try to manipulate it as well

Let's understand how CFO is calculated:

CFO = PBT + Non cash exp - Non operating income +/- changes in working capital - Taxes Paid

One can show high CFO/EBITDA by ⏫ CFO

CFO can be inflated by following methods:

1⃣Adding non-operating income or exceptional items as part of CFO

2⃣Make adjustments in working capital changes with items which are not part of working capital

⏫CFO leads to⏫cash conversion which in turn indicates good financials

A company was operating into 2 business segments and sold one of the business segment and recorded an exceptional income of 134 cr.

Normally such sales should be covered under cash flow from investing activities but the company has covered it under CFO.

💹💹

Another example we can cover here to understand how CFO can be inflated is considering non working capital items under CFO adjustments.

A pharma company has taken changes in loans & advances as part of CFO but it should be covered into cash flow from financing activities. 💊💊

The next area is to look into Related Party Transactions

RPT are transactions which are done by a company with promoters or persons or entities related to the promoters

RPT includes:
1⃣Buying or selling goods to RP
2⃣Loans to promoters or subs
3⃣Commission or exp to promoters

Let's cover some case studies:

A company operating in polyester films has improved its operating margins from around 10% to 22% which makes business looks interesting.

But when we dig deeper into it, we found some red flags in the Related Party Transactions of the business.🚨

Company has paid processing charges to the private company which is owned by the same promoters.

They paid around 49.80 cr as processing fees which is around 30% of its profit after tax.

We checked the financials of that private co & they are making EBITDA margins of ~65%. 🧐

Sometimes, companies give loans to promoters and then write them off later.

It indicates that the company cannot recover the money from the promoters.

It effectively means that the company has given free money to the promoters.

🤑🤑

One of India’s leading engineering conglomerates engaged in the manu of Agri-machinery🚜 has given advances to related parties and then write it off in the books

Which means related parties took loans from company and then never gave it back

Similar incidences in past as well

Too many related party transactions must raise doubts among investors about the willingness or the intent of the management.

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Thank you so much for reading.

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