One of the rare interactions by Mr. Nitin Mangal - Famous for his research reports on India Bulls, Reliance Communication, Vakrangee and others. he is one of the finest brains in the world when it comes to detecting accounting irregularities.
Read our Summary of his interview with one and only Mr. Varinder Bansal of Omkara Capital
One of the crucial points that Nitin Mangal mentions; look not only for operating cash flow but also free cash flow. The reason behind this statement is that operating cash flow doesn’t account for fixed capital capital expenditure and interest costs. If after deducting those I arrive at a positive free cash flow then it might be a good sign.
Nitin Mangal talks about a crucial line item which are known as “acceptances”, companies have been using “acceptances” to inflate the operating cash flow and consequently free cash flow. Acceptances are in a way denoted as short term working capital loans wherein you give the goods to the financier and take finance based on that. Now ideally it should have been a part of cash flow from financing but it is usually reported under cash flow from operating activities.
He also gives a wonderful insight that companies are way more smarter than the retail investors, and they hire consultants for gauging what really tricks the investor into believing that the company is doing well.
One of the formulae that he suggests to look into the company is looking at the variation between (EBITDA-Tax) and operating cash flow, it should be between 80 to 120%, In short the variation should not be more than 20%. If it is, it pays to investigate it more.
He mentions that never look at the financial metrics in isolation instead look at the whole story. (He gives the example of a company) Now if we deduct acceptances from the operating cash flow, the free cash flow comes out to be negative.
He mentions another astounding fact that more than 50 companies out of the top 300 companies have been doing this acceptances thing and inflating operating cash flow.
He gives an example for the idea that he mentioned related to EBITDA and operating cash flow variation; he says that a company posted really good numbers on income statement but not so good cash flow because most of the sales were getting blocked into receivables. Now because of that, the deviation between EBITDA and operating cash flow increased manifold.
He touches upon the real estate businesses wherein he spots the trend that the Un-billed revenue showed more growth than the revenue itself.
Nitin Mangal also touched upon a phenomenon wherein the companies were capitalizing the costs which in a way inflated the profit and loss statement and cash flow statement. Nitin Mangal talks about an item which is known as research and development expenditure. He states that such expenditures are part of the investing activities and not operating activities, but if you are analyzing a company which deals with innovation and are highly capital intensive the expenditure should ideally be considered as a part of operating activities.
He also takes the example of pension fund which are also not a part of operating activities, a phenomenon mostly seen outside India.
One of the crucial points that Nitin Mangal touches upon is that he deducts taxes from the EBITDA too so that ratio of CFO to EBITDA is more of an apple to apple comparison.
He mentions something about reserves and surplus category. He says mostly the reserves and surplus category is driven by profits. So if the cumulative profit is 100 rs for the last 10 years than the reserves and surplus should ideally show 70 rs; if not, there is a room for an investigation.
He also mentions something related to depreciation. If we want to analyse depreciation we should always look at it from a comparative point of view, which means that if the peers of the company are accounting for lesser depreciation as compared to the target company than there is a room for further investigation.
In a way when we charge higher depreciation we in a way pay lesser taxes, but paying less tax right now doesn’t mean that you can keep on doing that, there may be times when you have to pay comparatively more taxes (so basically do future discounting).
He says that most of the investors start with the consolidated financial statements and not from page 1. We are seldom aware of where the fraud might be actually cooking. So it pays to go through pages like special resolutions passed in the meeting, reading the corporate governance report and also secretary audit report.
In the secretary audit report we get to find the criminal cases against the promoter if there are any, other forms of dispute with the auditor, now such situations are not highlighted in the contingent liabilities. Nitin Mangal is asked about how to basically look at the cash flow deployment, so he gives the example of a company which had very little free cash flow but kept on paying dividends in order to lure the investor into the company. But if we look at the financial statements as a whole it is seen that the company is essentially borrowing to pay the dividends, so in a way they are distressing the balance sheet in order to pay dividends.
He mentions another line item by the name projects in progress in which he speaks about how inventory is valued. Normally in accounting we value the inventory on the cost basis, but one such company also capitalized the profits associated with the project in the inventory itself, so basically you are inflating the asset side of your balance sheet.
Companies also know where to hide the information because they inherently sense that the investor won’t really look at that part of financial statement. He says that most investors don’t read the standalone audit reports, he highlights a company which defaulted on a loan and nobody was aware of that scenario but when promoter said he disclosed the loan default, it was then found out that it was somewhere in the standalone audit statement.
He also highlighted about a line item related to fair value gain which was incorporated into operating income. In the operating income we usually account for the line items which contribute recurrently and are not a one-off event and also which are a part of company’s operations. Fair value gains arise out of revaluation accounting and if the component of fair value gains is of a significant chunk than the matter should be investigated further.
He stresses on the importance of reading DRHP (Draft Red Hearing Prospectus).
Watch Full: https://www.youtube.com/watch?v=dopgd6tZwsk