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What’s cooking at Manpasand, Vakrangee, Atlanta? How to spot red flags early

Sudden resignations by the auditors of a couple of companies..

Sudden resignations by the auditors of a couple of companies have triggered a sharp drop in their share prices in recent times.

Deloitte Haskins & Sells India quit as auditor of Manpasand Beverages a few days before the declaration of annual results. The stock plunged nearly 50 per cent in five sessions following the announcement.

Shares of Atlanta tumbled 20 per cent on Friday after Price Waterhouse chartered accountants resigned as its auditors.

Earlier, Vakrangee witnessed a similar development.

An auditor is responsible for the reliability of companys financial statements, as it is entrusted to carefully check accuracy of business records. An unexpected resignation leaves shareholders as well as lenders in the lurch, as they wonder if there is anything amiss in its books of accounts.

Why auditors quit?
Auditors have become bold and do not shy away from putting in papers if they find something suspicious in the accounts of a company. Some recent regulatory developments have also made auditors more conscious.

An auditor normally takes an easy way out, if he finds that the company management would not like his opinion, Dinesh Kanabar, CEO, Dhruva Advisors, told ETNOW.

He said there were issues earlier with the disciplinary powers of the Institute of Chartered Accountants and they have now been moved to an independent body, which looks at disciplinary cases. Therefore, there is a heightened fear among the auditors.

In a couple of cases, auditors have also been arrested and sent behind bars. No auditor would like to face that ignominy. Therefore, there is a heightened awareness within the profession about the audit role.

“If something goes wrong in accounts of the company, there is an awareness that the regulators, be it CBI or SFIO or an institute, would pile on the auditors,” Kanabar said.

Top Red Flags spoke to various market experts to identify early signs that something may be not above board in a company. Arpinder Singh, Partner and Head – India and Emerging Markets, Fraud Investigation & Dispute Services, Ernst & Young, shared five pointers:

Skewed business performance
Organisations exhibiting unusual profitability in saturated markets or in comparison to peers can possibly have trouble brewing within. Another red flag could be organisations with significant changes in financial ratios from previous year to current.

Absence or low implementation of policies or frameworks
Most organisations with global operations would need to comply with applicable Indian and foreign laws, which would require instituting policies or frameworks around whistle-blowing, code of conduct, code of ethics, anti-bribery or anti-corruption. Absence or low implementation of these policies can be a serious red flag, raising questions around corporate governance and ethical concerns.

Unusual related party transactions
Red flags can also be in the form of unusual related party transactions that would include inadequate disclosure of such transactions, fictitious or circuitous transactions.

Behavioural factors
Perpetrators of fraud can show certain behavioural signs that may be red flags. These include an apparent change in lifestyle, financial or legal issues, frequent disagreements with the company (compensation/ job rotation) and unusually close association with key vendors or customers.

Lack of tone at the top level as well as information or decision making generally restricted to few important individuals and lack of transparency in regular transactions can also be matters of concern. Value investors have a different way of looking for such aberrations. Generally, they try to look for such signs in the books of accounts.

Frequent fundraising/equity dilution
Normally, one should avoid companies that keep on raising funds by diluting equity. Value investor Ekansh Mittal, who is a Research Analyst at Katalyst Wealth, said, “While its not a sureshot sign of trouble brewing in a company, it does tell us the fact that either the company is trying to be too aggressive or the business is not self-sufficient enough to generate funds for expansion. It also tells us that promoters themselves dont value their equity much in the company and a lot of times such promoters have even siphoned out funds from the company.”

Too many acquisitions
Its well known that no matter how much the promoters talk about the synergies from the acquisition, most of the times the acquisitions turn out bad or the price paid turns out to be too high with a subsequent write-off. “An occasional acquisition of a company and that too of a manageable size (with respect to the acquiring company) is understandable; however frequent acquisitions are most definitely a red flag for us,” said Mittal.

Consistently increasing debt
There have been several examples such as Bhushan Steel, Amtek Auto where the companies debt on balance sheets increased with every passing year. The common pattern that market experts have found is sales and profits of such companies grow every year just like their debt, and suddenly one year, they report huge losses and become bankrupt.

While debt is a lifeline for capital-intensive businesses, however, if the company is not taking a breather and consistently expanding by taking on huge debt then some day or the other it will find itself in trouble.

Value investor Gaurav Sud, who is Managing Parner at Kanav Capital, said, “Many companies take debt to fund growth. While this strategy works well in good times, when the cycle turns, high debt levels cannot be served by cash flows, resulting in huge problems. While there is no golden rule, but any company where the debt-to-equity ratio is more than 1:1, one should study it carefully to see if it can sustain that debt in the case of a cyclical downturn (eg Jaiprakash Associates, Bhushan Steel, Reliance Communications).”

One should also look at debt servicing ratio of a company.
Amit Maheshwari, Partner, Ashok Maheshwary & Associates LLP said, “If the debt servicing coverage ratio is decreasing every year. It is being calculated by dividing EBIDTA with interest and loan repayment obligation in a year. If this ratio has come down to less than 1, it means that company has difficulties in repaying its debt and interest obligations. The possibility of converting the account into NPA is very high.”

Formation of too many subsidiaries
It has been observed that companies that form too many subsidiaries are generally up to something. “A lot of times, such subsidiaries are formed for the purpose of siphoning off funds. Basically, the modus operandi is that parent company offers loans to such subsidiaries, which then are unable to perform up to the mark or report losses and finally the loans and advances are written off. While there could be genuine cases as well, but a lot of times promoters take out money through such subsidiaries,” said Mittal of Katalyst Wealth.

High receivables
When you see that the debtors of a company are growing at a rate faster than that of sales then there is a big red flag. Gaurav said, “This implies one of two things – either the company is trying to increase sales by giving more credit in the market or the company is unable to collect money in a timely manner. This could happen due to lack of negotiating power with customers or they have a hard time to give money. At times this reflects outright fraud (Ricoh India).”

No or low tax payment
Sud also highlighted another important issue. “Many a time, there are companies reporting good profits but paying no or very low tax. This can happen because of tax exemptions or because the company is operating in a jurisdiction where there is no tax (eg Dubai / Mauritius). While there could be genuine reasons for paying no taxes, sometimes a company may be showing profits because there is no cost for show increased profits. Satyam Computers is a great example, which showed non-existent profits as there was no tax it for IT companies.”

Original Article


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