How to tell if a company is cooking its books

Until January, Indian IT firm Satyam was an investor favourite, thanks to its rapid growth, healthy margins and a cash pile of $1.1bn. One high-profile British manager had almost 10% of their India fund invested in the stock. Then chairman Ramalinga Raju made a shocking confession: it was all a sham. He'd been fiddling the accounts for years. Profit margins were just 3% and cash on hand was around $80m. The stock collapsed, the company has now been bought at a fraction of its old value and Raju is now stewing in a Hyderabad prison.

Should investors have been able to spot the fraud in advance? Unfortunately, there's no single test that will tell you if a company is cooking its books. Most of due diligence on investments boils down to forming an overall impression: for example, is the company structure oddly complicated, with lots of deals with related parties? This takes a lot of work; many investors don't have enough time, and put their trust in the fact that a major auditor PricewaterhouseCoopers in this case has signed off on the accounts. But there are a handful of quick and easy tests that can tip you off if something is wrong.

Follow the money

One giveaway with Satyam would have been the return it was earning on its cash or the lack of it. Interest income on cash holdings should be reasonably close to the prevailing interest rate in the country where the cash is parked. If interest earned is much lower than you'd expect, it could mean that some of the cash may not exist. Conversely, oddly high interest may point to a firm that's speculating in higher-risk investments to try to earn a higher return. More generally, it may be a warning if a large or rising share of income comes from investments rather than the operating activities that are supposed to be the company's main focus.

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In a similar vein, be careful when associates (other firms in which the company has a stake of less than 50%) seem to account for a large share of income. This can be a useful way of shifting heavily indebted, poor-quality subsidiaries off a firm's accounts, making its earnings quality and balance sheet look more attractive to investors, while still holding on to some of the earnings. But if the economy turns down and the associates hit trouble, those profits will dry up; even worse, the firm will sometimes have guaranteed part of its associates' debts to keep the bankers happy (if so, this should be disclosed in the notes to the accounts).

Watch out for working capital

You should always monitor a firm's 'working capital' the money used in its day-to-day activities. There are three parts to this: accounts receivable, which is money owed to the company; accounts payable, which is money owed by the firm; and inventories, which is the stock of raw materials, intermediate components and finished goods for sale.

It's easy to see how problems can be hidden in this section of the accounts. A firm can achieve apparently strong growth by selling goods on extended credit to lower-quality customers. This inflates this year's revenues and profits, but in the long run many of those accounts may be uncollectible. In the worst case, management may even fudge sales figures completely. Similarly, obsolete or even non-existent inventories can be carried at high values to make the balance sheet look better.

One good metric to keep an eye on is the cash conversion cycle. This measures the number of days between the outlay of cash on inventory and the point when you get paid by your customer. It's calculated as (average inventory over period/cost of goods sold) + (average accounts receivable over period/revenue) (average accounts payable over period/cost of goods sold, plus inventory growth in period), all multiplied by the length of the accounting period (eg, 90 days for quarterly accounts, 365 days for yearly accounts). If this number is high relative to peers and consistently rising, it may be a sign of trouble possibly because management is failing to keep a grip on cash flow, but perhaps because the numbers are being fiddled.

How real are the profits?

Exceptionally high profit margins lure in investors, but can also be a danger sign. Take care when a firm shows rapid growth in income without comparable growth in revenues; it may be concealing expenses artifically to inflate profits. One possible way to spot this is to compare the firm's effective tax rate (reported tax paid/pretax profits) with the tax rate that should apply to it. If the firm seems to be paying tax at a significantly lower rate than you'd expect and there's no obvious reason for this such as tax allowances or subsidiaries in lower-tax countries it could indicate that the firm is overstating its profits to shareholders.

Lastly, remember that what really matters is cash. Reported profits on the income statement and cash from operations on the cash flow statement can diverge for good reasons in the short-term, but eventually reported profits must be reflected in inflows of hard cash. Over time, the only real difference between the two should be the depreciation and amortisation of the company's assets.

Cash flow is not infallible. It can be faked for example, by juggling cash balances between related firms with different year-end dates, or by creating false bank statements. But this is harder than over-stating earnings. Focusing on cash flow rather than earnings will help investors to catch many frauds as well as spotting managers who are dressing up earnings to boost the share price and the value of their options.