6 Ways of Spotting a Fraud Company

Our body gives us signals every time we are about to fall sick. Be it a mild fever or something worse, it warns us before something is to go wrong.

Of course, this doesn't work if we are too busy to listen or see the warning signs.

The same thing happens with companies. Unknowingly, they also send out smoke signals. Signals that tell us that the company might be up to no good.

In today's article, we help you to interpret such signs. This way, you can protect yourself from any fraud or wrongdoing a company might indulge in.

1. Look for declining levels of cashflows

Often neglected, cash flow statements are like treasure maps for detecting financial fakery. It shows where the money comes from and where it goes. If used well, it can be an effective tool for analysis.

Ideally, any profits the company makes should reflect in the cash flow statement. However, this is not always the case.

Companies have mastered themselves in 'creative accounting.' So you will find several instances where the reported profits and the free cash flows don't match.

A cement company reported a profit for two consecutive years. But the cash levels on the balance sheet did not increase. The company was not in an expansion phase. So I looked at the cash flow statement.

On further analysis, I saw that they paid 'advances to a subsidiary' two years in a row. That too a subsidiary in an unrelated line of business.

This didn't bode well with me. It only showed how the company is misusing investors' money.

You should be wary of such companies, especially ones with a long history of such trends. Check to see why the profits are not generating cash for the company. Look for loopholes in the detailed notes to financials.

Unless a company is investing in growth opportunities, there is something fishy.

2. Related party transactions are never a good sign

A part of the financial notes in the annual report, this financial item carries crucial information. It tells you if the owners are using the company's money for their benefit.

Let's understand this better.

The owner of a company can have multiple businesses. But there is a good chance all his ventures won't do well. This can tempt him to use the money from his profitable ventures to fund the loss-making ones.

Now, if the founder is the sole owner, he is free to do anything. But this money doesn't belong to him alone. The minority shareholders have paid for a stake in it, giving them rights over that money. So, the owner cannot use it freely.

Now, sometimes founders go to the extent of creating bogus companies. This way, the money flows directly into their account.

The simplest way to check this is to go through every item in the detailed notes to finances in the annual report. And if you spot numerous related-party transactions regularly, know that there is trouble lurking.

3. Check to see if the company is recording sales without realising them

It is no secret that the markets love growth. Companies with growing revenues are everyone's favourite. Not only does it command a higher value, but it also incentivises the managers.

This kind of pressure can force managers to inflate their earnings. And they are willing to try anything.

A common approach is to loosen payment terms for the services or products rendered.

Once you make a sale, you record it. Now, this increases your revenue number on the financial statement. But the customer hasn't paid you yet. So you don't see any cash flowing into the company. However, it all makes sense on paper as your accounts receivable increases.

If this continues, the company will attract more financially weak companies. Eventually, it all comes together as one big write off or a financial charge.

Track the growth in the accounts receivable vis-a-vis the revenue.

A good thumb rule is the accounts receivable cannot grow faster than the revenue forever. It means that more is going out (goods and services) than coming in (money for the goods and services).

So if your revenue grows by 20% but your accounts receivable by 35%, it means the company is booking the sales but not realising it.

4. Frequent changes in accounting policies raise a big red flag

Look out for companies changing their accounting policies frequently. It's a common approach for masking bad performance.

A simple policy change can inflate the asset base or earning numbers. For instance, commodity companies can change their inventory accounting policies. They can move from last in first out (LIFO) to first in last out (FIFO) and vice versa per the market scenario.

Apart from this, companies can change their titles. In the early 2000s, many companies added 'Tech' to their title just because it was the new flavour in the market. Investors were looking for tech companies to invest in, assigning higher values.

Changing accounting policies often can muddle up the company's past. This makes the process of analysis cumbersome. So if you come across a company changing policies frequently, keep them at arm's length.

5. Find out the intent of the management

The key is to judge their ability and their intent. Judging the ability of the management is easy. You look at the company's performance.

But how do you interpret their intent? Let's find out.

Never go by what the management says they will do. Always look at what they have done instead.

Check to see how they have behaved during weak economic periods.

Have they stuck to the promises they made to the minority investors?

Did they deliver the growth and return numbers promised in its 5-year plan?

Do they have a history of cheating the minority investor?

Are they making good use of the excess cash the company generates?

Asking all the right questions is more important than the correct answer.

The board members of a company are not just the face of a company. They carry the authority to question the management and protect minority shareholders.

As per accounting standards, 50% of the board members must be independent. It means that 50% of the board members cannot be related to the management or the founder of the company.

But more important is the skillset the members bring to the table. Are they well-qualified to preside over the board of a company? Do they have relevant business experience? How active and responsible have they been with the meetings?

6. The CFOs or auditors leaving

Much like any other executive changing jobs, it is normal for a CFO to move around. However, if he leaves during difficult or suspicious times, it is a sign that something fishy might be going on.

The same logic applies to auditors or members of the compliance committee. While an auditor leaving might be too late a sign, you must be cautious of companies that change auditors and committee members frequently.

Evaluate the reasons behind the resignation. While it might be tough to find out the real reason, know that there is more to the story than meets the eye. Check to see if the fundamentals of the company are still strong.

Question everything while looking for loopholes. Talk to the competition and see what they have to say.

To conclude...

The Satyam Computers scandal of 2009 is a classic example of a black swan event. The auditors and the founder co-conspired to cook the books and fool the investor. The company reported a high cash and bank balance, which didn't exist.

Once the scam was out, it lead to massive destruction of shareholder value. Not only that, but it also put some people off investing in the stock market for a long time.

Foreseeing such black swan events is next to impossible. But these filters can help you insure yourself against them. The key is to examine the annual report. Try to read between the numbers. It can unravel secrets the company is trying to hide, effectively saving you from getting conned.

Happy Investing!