Will You Dump Your Client if You're Busy? Inox Wind's Auditor Just Did... - The 5 Minute WrapUp by Equitymaster
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Will You Dump Your Client if You're Busy? Inox Wind's Auditor Just Did...

Jun 14, 2018

Kunal Thanvi, Research analyst

What's the best problem a businessman can have?

I think it's having too many clients to handle.

Do you agree? I mean, if you're a businessman and the number of your clients grow, you will be happy, right?

But the stock market can be a strange place. This is what happened recently at Inox Wind Ltd.

The auditors of Inox Wind resigned because they were busy with other assignments!

This is what they wrote in their resignation letter...

  • 'Resignation is due to - time constraints caused by other commitments and engagements'.

Funny, isn't it?

Why would an auditor resign from an existing assignment and accept new assignments?

Another Auditor Resigns: Inox Wind Limited


Just to give you some perspective about this, as per guidelines issued by Institute of Chartered Accountants of India (ICAI), auditors cannot acquire clients by advertising.

This means, the only way they can acquire clients is by word of mouth.

This makes the issue more serious. In a business where you cannot acquire clients by marketing, it is not easy to let go of your existing clients.

If I was an auditor, I would have never done that.

In fact, I haven't seen any other auditor doing this because it is very difficult to acquire clients in first place.

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So, what is the real reason the auditor resigned? Nobody knows.

But, if we apply some basics financial analysis to Inox Wind, we'll find some very interesting numbers.

Some time back, my colleague Sarvajeet, warned our subscribers to stay away from Inox Wind because he suspected the company was cooking its books.

This is what he wrote...

    Companies can manipulate profit and loss by showing aggressive sales-to-book profits. However, book profits do not translate into free cash flow (FCF).

    So, checking the cash flow statement will help determine if the profits are being converted to operating cash flow.

    Let's have a look:

    (In Rs m) FY13 FY14 FY15 FY16
    Profit After Tax 1,504 1,323 2,964 4,519
    Cash Flow from Operation (CFO) -1,210 -760 -1,060 -3,906
    Source: Ace Equity

    Forget free cash flow, Inox Wind is generating negative cash flow. While revenues have shown healthy growth, Inox Wind's cash flows have not seen similar growth. In fact, they have deteriorated.

I think Sarvajeet nailed it.

A basic check required is for cash flow generation. If a company fails to generate free cash flow for a long period, it must be questioned.

The easiest way to cook the books of accounts is to book sales which never actually occurred.

As I wrote to you last week, I believe, this is just the start. You may see many more auditors resigning this year.

The reasons for the resignation can be as funny as they can get. But, the real reasons are very serious.

This has created fear among small & mid-cap investors. But as editor of Smart Money Secrets, I'm excited about the times ahead.

Why?

The reason is quite simple. This will lead to good corporate governance and better accounting practises.

And I believe we have got the first mover advantage here.

At Smart Money Secrets, we just love investigating companies like detectives, which helps us un-cover issues like this.

Our handy tool, the Smart Money Score, helps us eliminate companies with questionable books of accounts and corporate governance.

Chart of the Day

Talking about Inox Wind again, I believe the reason the auditor resigned is different from what they have mentioned. Look at the chart below.

It tells you a lot about the problems with Inox Wind.

The easiest and most used financial shenanigan is to fudge sales and profits. Companies book fictitious sales and profits. The profit and loss account looks glorified with profits touching sky.

However, these companies cannot fudge cash flows. Because they cannot recover money from the fictitious sales.

How Difficult Was It to Spot Inox Wind's Problem?

Over the period of FY13-16 net profits shot up by 3x, however, the company made operating cash losses which shot up by 3.2x.

Well, we don't believe it was rocket science for investors and auditors to figure this out.

And for investors to avoid the stock of Inox Wind.

The primary duty of an auditor is to verify what the company claims. However, since auditors are paid by the company itself, in many cases, the incentives don't align.

But now, this is all set to change with the new regulator the NFRA..

We believe, incentives need to get re-aligned and auditors need to do their fiduciary duty.

For us, this is like icing on the cake because, while evaluating a company for a Smart Money Secrets recommendation, we try to look at the numbers from an auditor's perspective.

This helps us avoid obvious mistakes like Inox Wind.

And we strongly believe, we can recommend stocks to our Smart Money Secrets subscribers for long-term wealth creation by avoiding these kinds of obvious and stupid mistakes.

Regards,
Kunal Thanvi
Kunal Thanvi (Research Analyst)
Editor, Smart Money Secrets

PS: In this volatile market, what are the best investors in India doing with their portfolios? Wonder no more. Kunal Thanvi is on a mission to reveal their best picks for you. All you need to do is follow India's top 40 super investors here...

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