Everybody talks about window dressing in financial statement but no body tells you about how it is done. Read on to know few well know tricks used by smart corporates.
Market are on rebound, Central banks are re-assuring the markets that they won’t let it fall and crash no matter what. Some of the investors with long term horizon may be looking at opportunity investment.
What long term value investor look at is the fundamentals of the company. They try to understand the few basic ratios such as price earnings, debt/ equity, return on equity etc. These ratios are published in many site that provide last 5-10 years of financial statement analysis. But there is a problem, the corporate cons and greedy insiders are on the move constantly looking to profit from the naïve retail investors.
These charlatans are master of hiding lies in the plain site. They cook up good looking financial ratios. How do they do it. Well these guys are innovative and they have use tricks. From Malaya to Nirav Modi to Wadhawan, they keep finding loop holes
However, it is entirely on the investor if he/she fails to look at details and ask some basic questions before investing their hard earned money in the shares of these companies. So, let’s see a few commonly used hiding places in financial statement
1. Loans from banks/ financial institutions or even public FDs
In financial statement, loans are reflected under balance sheet-à current liabilities & term or non- current liabilities. In finance “current” basically means “immediate” or “this account year”.
Loans although is an essential element of business, the crooks commit maximum number of frauds under this heading. Why because creditors be it banks / FIs are general public do not have access to day-to-day functions of these corporates. Lets see what are all the ways used to manipulate investors
Rate of return: One of the key ratio for long term investors is return on capital that the business is generating. This basically means how much profit each Rupee of capital (ROC) is generating per year. For example, if ROC is 30% each Rupee of capital generates 30 paisa of profit per year. Here is how corporate play with this ratio. Along with the capital they also add other’s money that is debt/loan to do business and generate profit. Then lenders are paid less than the profit share generated by their portion of capital. Confused? Ok.. Let me explain it with an example below.
Leverage during Good Times aka FOMO times:
Capital – Share holders’ money = Rs. 100
Loans/ Debt = Rs. 300 Consider yearly interest @ 7% = Rs. 21
Total Investment = Rs. 400
Yearly profit = Rs. 60 (Assume)
Return on investment = 15% (60 / 400)
Interest paid = 21
Remaining profit = 60-21 = Rs.39 (Profit available for share holders)
Return on capital = 39/ 100 = 39%
Profit available to shareholders is much higher than Interest paid to lenders… magic of leverage. Shareholders are able borrow 3 times their capital and take almost 2 times higher profit share than what was paid to lenders. This is awesome, what is the problem? you may ask.
You see here the actual return that business generates is only 15% but because that corporate leveraged 3X on cheap loan available at 7%, they showed a return on capital of 39% which is more than double that of actual return.
The problem is this: Debt have to be serviced no matter what the profit or loss is. Second loans are generally available cheap in good times when everyone is bullish. The same loan turns costlier when bad times hit and profit slumps. Let’s see what happens in bad times in the same example
Leverage during bad Times:
During bad times business see sales falling, profit diving and making higher provisions because customer don't pay up and default. Many businesses go in to loss during bad period but for simplicity sake let us consider that profit falls by 1/3rd or 35% to be exact in the below example
Capital – shareholders’ money = Rs. 100
Loans/ Debt = Rs. 300 Consider interest @ 8% (1%higher)= Rs. 24
Total Investment = Rs. 400
Yearly profit = Rs. 39 (Assuming 35% fall in profit)
Return on investment = 9.5% (39/400)
Interest paid = 24
Remaining profit =Rs.15
Return on capital = 15/ 100 = 15% (Return on capital dropped 50%)
(See the profit available to shareholders is less than interest paid on debts)
Here we have assumed very conservative numbers on rate of interest and profit dip, Rate of interest on foreign currency loan for corporates could be as low as 1-2% during good times and can balloon to 9-8% in bad times on account of foreign exchange risk.
Ace investor Warren Buffet does not invest in high debt companies and he himself has mentioned that he does not favor them because it is difficult to judge the actual return and high debt companies take bigger hit during bad times.
B. Another common fraud that we have seen is the diversion of funds.
This is extremely hard to find out from balance sheet unless the investor decides to dig deep into the kind of fixed assets financed. This is where the unethical bankers have failed investors. Banks have enough data to find out diversion of funds. But for some reason they don't report it or look the other way. Vijay Mallaya used bank loans of king fisher airlines to buy a private jet for himself. Technically the asset was still in the balance sheet of kingfisher airline that took the loan but instead of generating profits it was supposed to generate, it was idling away in the tarmac waiting for the bosses to finish off their booze party.
C. Siphoning off of funds:
This is what Wadhwans of DHFL did, they took loans/ debt and then lend it to house owners and that was later written off. Later it was found that the house owners whose loans were written off never existed. There were all imaginary borrowers.
Related party transactions are another easy way to siphoning off. Supply contract to given to firms owned by promoters. These firms over charge the corporate for services and supplies.
Investors need to pay attention to related party transactions, what kind of services they offer, what kind of interest free loans are provided to these related parties, how much of the receivables from related party are written off. etc.
Trying to understand financial statement can wear us down quickly. So we will stop here for now and will show what are the other black magic played by fly by night corporates in the next blog.
Thank you for reading. See you in the next blog