Please find below our key excerpts from a recent investor memo published by Congruence Advisors on how to check financial statement and management background to avoid being stuck in a business with bad corporate governance practices.
1 - Forensic analysis, channel checks, corporate governance evaluation, corporate structure & analysis of related parties are some facets that one needs to focus on to minimize the possibility of someone playing you for a fool.
2- Frameworks and checklists work very well in doing qualitative due diligence on a business. They ensure that you cover all bases and consider the perspectives that are worth considering. This does not ensure you make good returns from an investment, but it does minimize the possibility of losing a chunk of your principal on any investment over the medium term.
3- Is the company doing things that are drastically different from competition?
4- what is unique about the company’s product portfolio, distribution, pricing and positioning?
5- An investor should be able to find convincing reasons for why this difference exists while thinking independently.
6- In a business of this nature, what is the easiest way to siphon off money?
Ghost capex that somehow never yields much (monitor gross asset turns)
Inflated revenue for some quarters followed by a one-time write-off of AR
High R&D spends with little to show in terms of outcome
Below average operating cash flow, higher profits never trickle down into the cash flow
7- The usual routine is to show higher revenue and higher accounting profits to keep valuation high while the actual cash gets lent out/invested for their personal objectives.
8- History of frauds in the particular sector
Some sectors are more prone to frauds due to the very nature of the business. It is much easier to pull off fraud in a financial business than in a brick-and-mortar business. It is also much easier to employ creative accounting methods in a business that has intangible assets than in a business that needs tangible assets. Periodic M&A activity offers the possibility of further confusing investors through complex structuring, it also serves in ensuring investors never have a consistent basis for judging how the balance sheet changes over time.
9- Unit Economics – Do the numbers fit into the normal range for this category?
If the entire industry works at 16% EBITDA margin while a lone company claims 25% EBITDA margin, probe deeper.
Within a given industry, factors like credit period to the channel, credit offered by vendors, employee expenses, asset turnover all stay within the same range unless the technology/business model is drastically different.
Outliers always demand a deeper look before taking their numbers at face value.
10- Is accounting simple or complicated for this business?
A business that changes its accounting policy can see a sudden spike in revenue and profits.
Within the same industry vertical of financialization, asset management companies have very simple accounting while life insurers have very complicated accounting. Sometimes revenue is booked over years while costs are booked upfront.
11- Bad debt, Provisions and other write downs
A lack of understanding of how a lender classifies and provisions for NPA’s can sink investors.
How can one customer be an NPA for Bank 1 but be a good customer for Bank 2?
How do you recognize if loans are being evergreened by a bank? If a customer owes the bank 500 Cr but is unable to pay up, a bank can pass accounting entries to show as if the 500 Cr was paid back and lent out again.
My notes from a micro-cap I had recently analysed – “Bad Debt provisioning has been very high in 2019 and 2020, most likely cleansing of old sins by the new management. The numbers declared on the financial statements cannot be fully trusted, especially given the large delta change post transition to IND AS”. The stated asset values of this business on the balance sheet went up 1.5x after the transition to Ind AS in 2018. The same individual has been signing off on the company financial as the external auditor since 2011, of course from different companies.
12- Consistency in Taxes in P&L and Cash Flow
When you inflate revenue and profits, you make a provision for higher taxes in the P&L. But if that tax never gets paid to the authorities, there is a good possibility that the numbers are bogus.
13- Check the ageing structure of the AR, see what % of that is being written off as bad debt under other expenses.
14- What is the nature of the contingent liabilities? Any litigations that the company is under?
15- What % of the finished goods inventory has the company been holding for > 2 years in the case of a consumer company?
16- How much is due from related parties? Is this balance increasing or decreasing over the years?
17- Does the promoter make investments into unrelated areas? Either through the company or through his personal funds?
18- What percentage of the promoter holding is pledged? Is this for reasons related to the business or is it for other reasons?
19- The business being evaluated accounts for what % of the promoter net worth?
20- It is not out of place to see some promoters being directors on a few real estate holding and construction entities. These would most probably be land banks that they acquired over a period of time and are now monetizing. But if a promoter is associated with too many unrelated companies, it is time to drill deeper and understand why.
21- Birds of the same feather flock together. What is the nature of the others individuals who are directors in these companies? Key work search for each of the directors and companies can reveal some surprising insights.
22- Together raise funds when you do not have a specific purpose with a specific timeline?
23- Any business that keeps diluting equity every 3 years (unless they are in the business of lending money) poses questions about both the intent of the promoter and the quality of the business.
24- A listed lifestyle and health business dip a QIP and sat on 200+ Cr cash for more than 3 years. One fine day they went out an opened 20 centres in the same city! Over the next few months, they went out and acquired a chain outside India, when their annual report said India is a largely underpenetrated and unorganized business for their market.
25- Managing expectations is very important to the investing community. When managements come out and start making over the top statements and lofty projections that will be tough to execute.
26- Some businesses suffer from a “valuation discount” due to this, most managements learn from their mistakes. But if the same trend continues over a period of time with a stock price that fluctuates wildly following announcements, you may well be looking at an operator driven story.
27- What are the related parties? What is nature of engagement with them?
Good promoters do not have other businesses that compete with their listed business. At best they might have a few entities which act as marketing/distribution agents in an effort to transfer some risk away from the listed business. Especially when the law of the customer land is different. But if you see the promoter’s nephew/relative running a similar business, it cannot be a positive in any sense.
What is the nature of financial transactions between the entities? It is just a leasing/distribution/rent agreement executed on market terms, or is the promoter family using it to benefit at the minority shareholder’s expense?
28- How many subsidiaries does the company have? What is the stake in them?
A large listed NBFC has more than 100 subsidiaries with complex interlinkages. There are corporate guarantees, inter corporate deposits and lending arrangements. One of its smaller listed peers has just 18 subsidiaries and the objective of each one of them is very clear. There are minimal interdependencies across these entities.
It is not just about whether the promoter is creative right now, it is also about the leeway they have given themselves to get creative if and when they want to.
29- What is the promoter remuneration? Do the board members get just a sitting fee or a commission too?
30- What is not acceptable is for an independent board member to get a sitting fee of INR 20 lakh for attending 4 board meetings a year.
31- What is the auditor remuneration? What has been the trend?
I have seen a Hyderabad based financial technology company (I still cannot comprehend what they do) spike their auditor fee from 2 lakh to 25 lakhs within 2 years
What other customers does the particular auditor serve?
32- What is the constitution of the board? Are there enough members who have reputations outside of the business at stake?
If the promoter family is leagues above the independent board members in terms of social status and stature, I see it as a possible red flag.
If the promoter family is leagues above the independent board members in terms of social status and stature, I see it as a possible red flag.
33- I also triangulate the insights from credit rating reports and see if the story adds up before coming to any conclusions.
34- None of this can rule out accounting errors/frauds totally but it does reduce the possibility of you getting caught in a story that had some obvious red flags to begin with.