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9 Warning Signs For Investors To Detect Fraud Or Financial Distress In A Company
Warning Signs For Investors To Detect Fraudulent Companies In Stock Market

9 Warning Signs For Investors To Detect Fraud Or Financial Distress In A Company

#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

Let’s Begin.

Pledge

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.

CCD Promoter Pledge Details

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 critical financial ratios to avoid investing in indebted companies

2. Continuous Decline In Promoter Shareholding

decline in promoter shareholding

If the promoter is selling his stake then it’s a matter of concern. Promoters know much more than us about what’s cooking inside the firm.

For example, in case of Satyam Computers, company was reporting increasing sales and profit numbers.

Investors would have loved the financial numbers reported by Satyam. Have a look at the profit loss statement from Mar 2006 to Mar 2008 before the accounting fraud came to light in Jan 2009.

Sales increased from 4793 crores in Mar 06 to 8743 crores by Mar 08. Net profit increased from 1142 crores to 1688 crores in Mar 08. Pretty Impressive. Right?

warning signs to detect fraud and financial distress satyam computers profit loss statement

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.

As per this articlestake held by promoters of Satyam computer continuously declined.

declining promoter stake satyam computers

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

This needs to be explained with an example. Vadodra based, Manpasand Beverages is the owner of brands like MangoSip, Fruits Up etc. May be you have tried many of their beverages.

It’s shares were listed on the stock exchange on 24th Jan, 2015. Company was reporting increasing profit year after year.

Have a look at the profit loss statement of Manpasand Beverages.

Sales increased rapidly from 85 crores in Mar 12 to 948 crores in Mar 18. While the profit after tax surged from 6 crore in Mar 12 to 100 crore in Mar 18. That is stupendous growth. Kind of unbelievable.

warning signs to detect fraud or financial distress manpasand beverages profit loss statement

Everything was going fine until their auditor Delloit Haskins & Sells, India resigned in May 2018. As a result of this the stock crashed.

Later the company was also accused of 40 crore GST fraud.

Forget the small investors. As per this ET article, seven mutual funds from the likes if BNP Paribas, ICICI Prudential Fund, Kotak Mahindra Mutual Fund, Motilal Oswal etc, lost significant money in Manpasand Beverages.

It was very difficult to figure out that this company could be manipulating its numbers.

Well it may have been difficult but there is something that happened one year before the crash that could have provided a clue.

Manpasand Beverages Needs More Time To Review Financial Statements

Here is something interest that happened in 2017, long before the stock crash in May 2018

a) Maspasand declared on 20th May, 2017 that a board meeting will be held on 29th May, 2017 for submitting the financial results for financial year 2017

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.

meeting on 29th Therefore Manpasand Beverages was suppose to declare its results for FY17 by 30th May, 2017.

You can click here to check the compliance calendar for BSE

Now comes the twist.

b) Management holds a meeting on 29th May, 2017 as promised. Ideally they should submit the results to the exchange by end of the day. Well that was not to happen. Instead the management decided to defer the results.

The results were deferred due to further time required for the review of financial statements prepared uner IND-AS and auditing.

signs to detect fraud and financial distress manpasand beverages defers financial results

This is big red flag for me. Management waits until the end of deadline to submit the financial results and then decides that they need more time to review the financial statements.

This is difficult to catch but in future if you as an investor ever come across such statements and delaying of results then please tread with caution.

c) Had you as an investor seen this in 2017, you could have saved yourself from a financial disaster. Why? The stock crashed from 440 Rs in May 18 to 10 Rs at the time of righting this post.

4. Companies Keeping Huge Sums Of Cash In Current Account

lots of cash

Often investors come across companies that have huge cash reserves but they don’t want to give dividends or reduce the firm’s debt.

Most weird thing I have seen is that a large pile of cash lies in current account. Let us see a few examples.

Satyam computers whose promoter confessed to accounting fraud reported significant cash reserves in their balance sheet.

As per the article from Economic Times, its cash in current accounts increased from 600 crores in Sep 07 to 2000 crore as of Sep, 08.

Therefore out of a total cash reserve of 5300 as of Sep, 08, 2000 crore was lying in current account as of Sep, 2008. 

Why would you keep so much money in a current account that does not yield any interest? 2000 crore could have earned a lot of interest for the company’s shareholders.

Another example is Kitex Garments where company had kept around 245 crore.

2000 crore could have earned a lot of interest for the company’s shareholders.

This amount was kept in dollars and was not earning any interest. Promoter was waiting for Indian Rupee to depreciate further so that he could convert this to INR.

 

Below is a snapshot from Kitex garments 2016 annual report. You can see company has kept 245 crores in current account.

signs to detect fraud and financial distress Kitex garments cash in current account

How To Check For Large Sums Of Cash In Current Account

If you see a lot of cash on the balance sheet it is important to go one step further.

 

For stocks listed on Indian stock exchanges, one can make use of screener or moneycontrol to check for cash reserves under balance sheet.

 

Please find below a snapshot of balance sheet of Satyam computers highlighting the
cash reserves.

satyam computers balance sheet

Once you find large cash reserves, please go to the annual report and check if the company has been keeping cash in current account for several years.

 

You can find all such data in annual reports (A simple ctrl + F for cash can help you find this).

 

Henceforth, be wary of companies with lot of cash but not repaying debt using that cash or having low dividend payout ratio or keeping cash in current account.

5. Companies That Love Giving Loans & Advances To Subsidiaries

Companies can extend loans or advances to their subsidiaries. When a company gives a loan to its subsidiary it is shown in the assets side of the balance sheet.

 

Note: subsidiary is a company in which the parent company holds more than 50%stake.

 

This channel is often misused by promoters to take out money from the parent company

to its subsidiaries.

 

In fact many companies borrow money from banks and then use loans and advances to route it to various subsidiaries. Let us try to understand with an example.

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.

As per the article from moneycontrol, Unitech’s directors have allegations of siphoning of funds received from home buyers.

 

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.

 

As per the article from Times Of India, Unitech’s forensic audit revealed that funds for construction projects taken from home buyers and banks  were used for purposes other than construction. They also diverted these funds.

 

Now whether you are an investor in stock of Unitech Ltd. or whether you invested in one of their real estate projects it is always advisable to check the financial statements of the company.

Here's How An Investor Could Have Avoided Investment In Stock Of Unitech Or Investment In Their Real Estate Projects

Let us see a snapshot of Unitech’s balance sheet. As per the data from Stock screening and analysis tool, Unitech’s loan and advances increased from 285.98 crores in Mar 08 to 16931 crores as of Mar 19.

 

unitech ltd loans and advances

You can easily find these loans and advances in the balance sheet.

 

These loans and advances indicate money flowing out of Unitech to other entities. Since the quantum of money is huge it raises suspicion.

 

If you see a lot of funds reflecting in loans & advances then please check the annual report to verify to whom are these loans being given.

 

 

Please see pages 81 to 84 of this annual report 2008 to see the loans and advances being given to their subsidiaries.

 

As an investor we cannot be sure whether these loans and advances are genuine or not but they do raise suspicion.

 

As a shareholder it is better that the funds are not diverted from the company in which he/she is invested.

 

In Unitech’s case majority of the loans were given to their subsidiaries. You can read more about Unitech here.

 

Cox & Kings is also a similar exampleAs per ETCox & Kings loans and advances to subsidiaries jumped to Rs 1,464 crore in FY18 from Rs 468.5 crore in FY14.

Also, investments in overseas subsidiaries have jumped to Rs 220 crore in FY18 from Rs 115 crore in FY13.

 

6. Companies That Love To Creat Subsidiaries

subsidiary is a company in which the parent company holds more than 50% stake while an associate is a company in which the parent company holds between 20% – 50% stake.

 

Most companies create subsidiaries and there is nothing with just the creation of a subsidiary. It is when a firm may create an unusually high number of subsidiaries that raises suspicion.

 

Especially if, as an investor we see that a lot of money of the parent company is being routed to these subsidiaries and associates by means of loans and advances or by way of investments.

 

 

As per 2008 annual report of Unitech ltd it had 323 subsidiaries incorporated in India and 28 incorporated outside India (check pages 52 – 55).

 

That’s a whole bunch of subsidiaries. Along with this we also saw earlier the quantum of loans and advances Unitech Ltd was extending to them.

 

You can find a similar trend in Cox & Kings. Just view the annual report of 2017.

 

From page 42 to 51 you will find that company had 139 subsidiaries and associates. Along with this came the increase in loans and advances.

 

Once you see a combination of high number of subsidiaries and increasing loans & advances or investments by the parent company in them, it is better to avoid investing in such firms.

7. Investment By Company In Unrelated Businesses With Large Capital Outlay

Many a time promoters of a company may decide to invest capital in a totally different field.

 

For example a chemical company may decide to invest in hotel business or a real estate company may invest in telecom business.

 

As an investor I do not see this as a great thing because the management in most cases holds less experience in a new field.

 

Let us understand this with a recent saga that unfolded in Zee Entertainment Ltd.

 

Mr. Subhash Chandra the founder of Zee, himself stated that his over leveraged bets in the infrastructure space led to 4000 to 5000 crore of losses.

 

Zee entertainment has always been the cash earner but later investments in to Zee learn (a business in education sector), Dish TV etc proved to be a disaster.

 

This may not always be bad but generally infrastructure businesses require large amount of capital and Zee’s saga is an example of such bad investments in unrelated businesses. 

 

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

All said and done. Imagine you are a long term investor in Zee Entertainment Ltd and all these new ventures have been unfolding in front of you for past several years.

 

What should have triggered your attention is the continuous increase in pledged shares by promoter.

 

As per this article from ET there was a continuous increase in pledged shares from 41.93% of the promoter holding pledged in Dec 16 to 59.37 % of promoter holding pledged as of Dec 2018.

 

Even as of Dec 16 the percentage of pledged shares (as a percentage of promoter holding) was pretty high at 41.93%. As an investor one should have exited the stock based on such high proportion of pledged shares.

 

The promoter had to pledge shares to fund other group companies which required heavy investments but could not generate sufficient cash.

 

The result of all this is that the promoter will be selling 16.5% of 22.37% stake and become a minority shareholder from a majority shareholder.

 

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

businesses.

8. High Debtor Days & Negative Cash Flow From Operations

Most companies often make sales on credit to customers. Imagine you are a cooler manufacturer who sells one cooler for 10,000 Rs.

 

Consider that you sell 30 coolers in a month. In such case your total revenue will be 3 lakh rupees. Now suppose you sold 15 coolers on credit for which you will receive the payment 90 days later.

 

In such case the revenue for these 15 coolers totaling 1.5 lakhs is termed as receivables and the time taken to collect these payments (90 days in this case) is termed as debtor days.

 

In essence receivables are sales on credit for which money is received on a later date and the number of days it takes to collect money for sales on credit are called debtor days.

 

Now if you as a cooler manufacturer keep selling coolers on credit and your customers do not pay on time your firm will start facing a cash crunch. It can lead you to borrowing more money to fund your day to day operations for cooler manufacturing.

 

Investors give great importance to receivables to sales ratio along with the debtor days.

 

A receivables to sales ratio measures the percentage of sales made on credit as a percentage of total sales.

 

In our example above, the cooler manufacturer had receivables to sales ratio of .5 and debtor days stood at 90 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 eco products debtor days

A few observations from the above data are as follows:

 

1. Jiya Ecoproducts has very high debtor days as of Mar 19 (days required by a firm to collect money from its customers for sales on credit). Jiya on an average takes around 223 days or more than 7 months to collect money from its debtors.

 

2. Debtor days show an increasing trend from 88 days in Mar 15 to 223 days in Mar 19This 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.

 

Company’s capital is getting blocked with the customers in the form of credit sales for 223 days.

 

3. Even though Jiya reported cumulative profits of 31.33 crores from Mar 15 to Mar 19, it’s cumulative cash flows from operations were a negative -22.85 crore.

 

A negative cash flow from operations indicate that company has been losing cash
while running its day to day operations.


Please click here to read more about cash flow from operations


One should invest in companies with positive cash flow from operations as negative cash flows from operations indicate that the company is losing cash from its operations.

 

4. Receivables to sales ratio increased from 24% in Mar 15 to 61% in Mar 19. This means that company is generating more sales on credit each year. This again is not a good sign.

There is another angle to this story.

Curious Case Of Promoter Selling In Jiya Ecoproducts Despite Increasing Profit

jiya eco products shareholding pattern

Another interesting thing I observed was that while profits were increasing, promoters were off loading their shares to the public (source stockedge app).

 

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

merger and acquisition

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.

Let's Summarize

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.

I hope you liked the article. Please make good use of these parameters to protect your capital by detecting fraud or financial distress in companies chosen for investments early on.

Feel free to share your experience of investing in a fraudulent firm in the comments section below.

Don’t forget to share this article and Do Subscribe. Happy and Safe investing folks.

Disclaimer : Stocks mentioned in the post are only for tutorial purpose. Author does not recommend any stock. Please do your due diligence before investing.

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