#9 Warning Signs To Detect Fraud Or Financial Distress In A Company
Where there is smoke there is Fire. Do you remember the Satyam fiasco that shook the Indian stock market?
Mr Ramalinga Raju, the erstwhile promoter of Satyam Computers was manipulating the accounts of the company for close to 7 years.
While the investors enjoyed a bull run in the stock, they were totally unaware that they were riding a tiger.
From a high of around 500 Rs a share in May, 2008 to 6 Rs a share in Jan 2009. So let’s say you invested 1 lakh Rs in Satyam Computers in May 2008, your wealth would have reduced to 1200 Rs by Jan 09.
That’s how badly an investor ended up getting hurt in a company which seemed to be making a lot of profit for its shareholders. This brings us to the question.
Should we stop investing because we as small investors can never figure out the games played by big boys?
Well. If you were to ask me. I would say never stop investing. Why? A ship in a harbour is safe but that’s not what ships are made for.
Playing too safe in life is not living a life. We should take risks but calculated ones. Before you dive study the patterns to avoid the pitfalls. That’s exactly what I am here to tell you today.
In this post I am going to share with you the warning signs that begin to flash as a company becomes unfit for investment. Signs to detect fraud or financial distress in a company.
These indications will help you be better prepared to avoid a stock crash resulting from fraudulent transactions or deteriorating financial condition of a company
1. Pledging Of Shares By Promoter
Promoters of debt ridden companies often pledge their shares with financial institutions.
They may do this to raise money for the firm or for other intentions best known to them.
Pledging of shares by promoter is very much evident in all recent financial disaster that hit the Indian stock market
A few examples of such companies are Jet Airways, Zee Entertainment, Reliance Communication, Coffee Day Enterprises etc.
Note: In case you are new to the concept of pledging of shares, Click here to know more about pledging of shares by promoter. From the table of contents select promoter pledging of shares.
Debt within reasonable limits is good but when borrowed out of proportions leads to financial disasters.
We can consider the example of Coffee Day Enterprises whose promoters had pledged more than 75% of their shareholding.
As per this article, debt created so much pressure on the founder, VG Siddhartha that it led to his unfortunate suicide.
Debt has forced Coffee Day Enterprises to sell its Global Village Technological Park In Bengaluru. This is being done to reduce the debt burden by 2700 crore.
Here is a snapshot of the percentage of pledged promoter shareholding in Coffee Day Enterprises.
The stock of Coffee Day Enterprises crashed from 297 Rs in Mar 19 to 32 Rs as of 17th Jan, 2020.
Pledging of shares can also be seen in companies manipulating their accounts. Satyam Computers is a perfect example.
We will read more about this in the second warning sign to detect fraud and financial distress in a company
How To Avoid Such Companies
Coffee Day Enterprises All it requires to avoid such companies is to look at the following parameters:
1. Debt to equity ratio for the firm is > 1.2
2. Along with high debt to equity we need to check if the Interest coverage ratio is < 3
3. Percentage of Promoter Holding Pledged > 10%
You can read about the three points above with detailed explanations by visiting the link below:
2. Continuous Decline In Promoter Shareholding
If Satyam was generating such bumper profits why were the promoters selling or pledging their shares. Instead they should be increasing their stake in the company.
Promoters held 25.6% stake in Satyam computers in 2001 which gradually declined year after year to 8.74% in 2008 (around one year before the scam).
Therefore if you see a big reduction in promoter shareholding, it is better to sell your investment and look for a better company where the promoter is increasing his stake
3. Delay In Declaring Financial Results
Manpasand Beverages Needs More Time To Review Financial Statements
Please note that the deadline for submitting annual financial results is 60 days from the end of financial year.
So when the financial year ends on 31st Mar every year, maximum time permitted to a company to submits its annual result is 60 days from the end of financial year.
4. Companies Keeping Huge Sums Of Cash In Current Account
5. Companies That Love Giving Loans & Advances To Subsidiaries
Unitech Ltd The Real Estate Major That Went Bust
Unitech group was one of the largest real estate builders in the country. Unitech group is known for building malls like Noida’s The Great India Place, Gurgaon central, Delhi’s Rohini Metro Walk etc.
In 2017, Supreme court had rejected the bail plea of the promoter Mr. Sanjay Chandra and Mr. Ajay Chandra. They failed to deposit 750 crores to compensate 16300 buyers waiting for completion of their houses.
Here's How An Investor Could Have Avoided Investment In Stock Of Unitech Or Investment In Their Real Estate Projects
6. Companies That Love To Creat Subsidiaries
7. Investment By Company In Unrelated Businesses With Large Capital Outlay
Zee is a case where the promoters could not utilize the excess cash generated by Zee Entertainment properly.
This led to poor investments in companies that required more capital which in turn led to pledging of shares by promoter.
Promoter Pledged Shares In Zee Entertainment Should Have Alerted An Investor
As per this article from ETpledged shares from 41.93% of the promoter holding pledged in Dec 16 to 59.37 % of promoter holding pledged as of Dec 2018.
As an investor one should have exited the stock based on such high proportion of pledged shares.
In short, Mr Subhash Chandra as a minority shareholder will not be able to exercise absolute control over the company, its management etc. All this due to diversifying in to cash guzzling
8. High Debtor Days & Negative Cash Flow From Operations
Now suppose you sold 15 coolers on credit for which you will receive the payment 90 days later.
receivables and the time taken to collect these payments (90 days in this case) is termed as debtor days.
Companies can show increased sales on their profit loss statement by showing more sales on credit. This is a prevalent practice to boost sales numbers.
Understanding With An Example
Let us consider the example of Jiya Ecoproducts (manufacturer of Biomass pellets).
Jiya on an average takes around 223 days or more than 7 months to collect money from its debtors.
.This means that the time to collect money for sales on credit has increased from 3 months to more than 7 months. This is not a good sign
Curious Case Of Promoter Selling In Jiya Ecoproducts Despite Increasing Profit
It is clearly evident from above data that promoters have been selling their shares to retail investors from Mar 18 till Mar 19. Coincidentally, stock began to fall post Jun 19 from 84 Rs to current price of 26.6 Rs a share.
9. Avoid Companies On Acquiring Spree & Paying Insane Amounts For Acquistions
Overvalued acquisitions can lead to acute financial distress in companies.
Tata Steel acquired London based Corus in 2007 when global steel market was showing good demand.
Tata Steel bought a company that was nearly four times their size and they paid 12.1 billion dollars for Corus acquisition.
Tata steel had to increase their bid price for acquiring Corus by 34% over their earlier offer when Brazil’s CSN joined the bid to takeover Corus.
Tata Steel Europe (earlier Corus Group renamed Tata Steel Europe in 2010) has been mired in losses since the acquisition and it has been forced to sell its assets many a times.
They have also had to cut jobs on several occasions. Tata Steel Europe’s cumulative losses have been pegged at Rs 48,245 crore over last 10 financial years.
Remember steel is a commodity cyclical business and whether you are an investor or enterpreneur you need to be aware of the fact that buying when prices are high is the worst thing you can do.
Such ambitious and overvalued acquisitions a year before the global financial crisis is a big mistake.
Etihad Airways An Example Of Failed Acquisitions
Another example is Etihad Airways that went on a shopping spree in 2013.
As per this article from Bloomberg article Etihad Airways reported a loss of 9090 crores as of Mar 2018. This means a combined loss of 34121 crores over last three years.
As per this article from Forbes, Etihad’s acquisitions have led to huge losses.
The article cites that Etihad made an investment of 510 million $ in Air Berlin, 650 million $ in Alitalia and 529 million dollars in Jet Airways. All three have gone bankrupt.
They just went on a shopping spree purchasing nearly insolvent airlines. In 2016, investments in Alitalia and Air Berlin led to a setback of 808 million dollar.
On top of this German bankruptcy administrator is suing Etihad for 2 billion EUROS.
Therefore as an investor avoid firms which go on an acquiring spree and pay massive amounts to acquire other loss making companies.
Following parameters can help an investor detect fraud or financial distress in a company early on.
1. Avoid companies with high debt and high percentage of pledged promoter holding
2. Be cautious about companies keeping large amount of cash in current account for several years
3. Be wary of companies with too many subsidiaries, lot of loans and advances to subsidiaries or investments made in subsidiaries
4. Keep tab on debtor days and receivables to sales ratio. Avoid investing in companies with negative cash flow from operations despite showing profits.
5. Be watchful of companies that want to acquire everything on Earth and that too by paying exorbitant amounts at the height of stock market boom.
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