How to identify if company is cooking up its books?

Here in this article, we have tried to mention factors which can let you know if the company might be inflating their books.

The first point that I would like to mention here is related party transaction. This is the most common thing that companies tend to do to inflate their performance which can include sales, leases, service agreements and loan agreements with its subsidiaries or other companies owned by the promoters etc. Thus this raises a red flag, higher the related party transaction in proportion to sales, higher the possibility that the company might be involved in cooking its books.

The second factor that one can look for checking the company’s genuineness is CFO-to-EBITDA ratio. This ratio indicates the company’s strength and ability to convert its EBITDA into operating cash flow which is a bit difficult to manipulate. The company might be manipulating its sales in various ways like channel stuffing. The higher the ratio, the better it is as it states that the company is in a comfortable position to convert its profit into cash.

If the company is recognising higher or lower reserve such as restructuring reserve, loan-loss or bad-debt reserve etc. these would inflate the current year’s profit but at the expense of future profit or vice versa. 

The sudden resignation of the company's auditors also raises a red flag about the company’s operation. In the recent past, companies such as Vakrangee, Manpasand Beverage etc faced the wrath of investors when their auditors refused to give them a clean chit and resigned. Besides, the disclaimer in the audit report should be one of the key things to read from the annual report. Also, material non-audit work performed by the company's auditor should also be a cause of concern. The other factors such as auditor’s remuneration as a proportion to sales as against its peers should be verified. 

Further, one more important factor that should be on the checklist is the depreciation policy as against the industry practice. A different depreciation practice can help the company twist its earnings. 

Also, increasing debtors and divergence in provisioning from the peer group companies should be carefully watched by investors.

We have tried to mention the factors that may indicate or reveal the true picture of the company, but you should not restrict your analysis to these factors only.