The presentation was done to highlight habit of Annual Report reading to identify patterns of accounting and ethical malpractices and an overall checklist to identify signs of trouble.
2. Agenda
• The company in focus, let us say XYZ, went burst somewhere between Apr-2015 to Jan-2017
• Could we have sensed it by 2014 that there could be such risk?
• Let us try to find through annual report analysis
• Before we start with annual report, let us start with quick look of financial numbers to get a sense on
what all we want to search in annual report though we will read each line in detail
• Concluding Remarks : What to look for in annual reports
Note: To keep the audience guessing, we will 1st go through only those sections of annual report where easy guessing about company is not
possible until one has gone through annual reports in detail
3. Key Points from Quick Financial Analysis
• What is working
o Revenue Growth
o PAT Growth
o Good Liquidity Ratios like debt to equity, quick ratio etc.
• What is not working
o Huge PAT to CFO Mismatch
o Huge CAPEX to PAT leading to very negative FCF
o Highly working capital intensive
o Gradual increase in receivables and increasing debtor days
o Sudden increase in other expenses
o Highly fluctuating expense items
o Low RoE and RoCE
• What needs to be understood in detail
o Why high Gross Asset/Revenue Ratio without any improvement
o Why regularly high CAPEX required without improvement in asset related ratios like asset turnover, return
on assets – accounting and cash
5. Annual Report : 2010-11 – Balance Sheet
• Why so much rise in loans and advances
, to whom it has been given?
• Why sudden increase in cash?
• why liabilities have increased 3 times?
7. Annual Report : 2010-11 – Cash flow statement
• Why so much of loans and advances. Will financial charge
and interest on FD will be a part of cash flow from
operations?
• What is business commercial rights? who is being paid?
why?
8. To look for these answers, let us get into details of schedules of each item
Additional Questions so far…
Balance Sheet:
• Why so much rise in loans and advances , to whom it has been given?
• Why sudden increase in cash?
• why liabilities have increased 3 times?
Cash flow:
• Why so much of loans and advances. Will financial charge and interest on FD will be a part of cash flow from
operations?
• Was is business commercial rights? who is being paid? why?
9. Annual Report : 2010-11 – Schedules
• Why company adding freehold land? 5 crore of 32 crore asset is land. Are they going to utilize it for business?
• 7 crore out of 38 crore of asset is goodwill and brand
• 12 Cr out of 38 Cr i.e. 33% of assets is either land or intangible like brand. Also, please remember (quick financial analysis)
gross asset to revenue, return on asset, asset turnover ratios were poor
10. Annual Report : 2010-11 – Schedules
• 2.6 crore investment into infra company.
(Remember IT company getting into infrastructure, not
doubting but better to ask questions)
• Why cash is pledged for working capital loans, is not
hard assets enough specially 7 crore of land?
11. Annual Report : 2010-11 – Schedules
• Why such huge loan/security deposit
given to directors?
• Why 10 crore of interest free loan given to
employees? Is it a fair transaction for
shareholder?
12. Annual Report : 2010-11 – Schedules
• Why auditor remuneration doubled?
• 33% of expense is miscellaneous. Is
it too high for miscellaneous?
13. Annual Report : 2010-11 – Related Party Transactions
• What is additional lease deposit? Why it has
been provided?
• why KMP is being given money for fixed asset
purchase and office purchase on personal
name?
CEO Salary
14. Annual Report : 2010-11 – Other Details
• Taking auditor’s service during IPO
and paying separately for that is it a
common practice?
• why company giving bank guarantee for
loan to director?
15. Annual Report : 2010-11 – Accounting Policies
Intangibles
(i) Cost incurred for acquiring brands are capitalised and amortised on a straight-line basis over a period of ten years, being the estimated useful life.
(ii) Goodwill arising from acquisition of business is amortised over the expected useful life, not exceeding ten years.
(iii) Business Commercial Rights i.e “facilitation service rights” acquired from various Trusts/Societies are capitalized and amortised on a straight line
basis over a period of thirty years, being the estimated useful life.
Revenue Recognition
Income from Services is recognised on rendering of services and is recognized when there are no significant uncertainties as to its measurability or
collectability. In instances where fees are received during a term, revenue is recognised on a proportionate basis for the period which falls under the
current reporting period and the balance is shown as advance fees received.
Revenue from consultancy services is recognised on rendering of services, as evidenced from the customers’ acknowledgment of
services received. In respect of non refundable consultancy services to franchisee for setting up of its operations, the receipt of service
generally coincides with signing of the franchisee service agreement.
Business Commercial Rights
The Company has entered into an exclusive facilitation service agreement with various bodies based on which the
Company has exclusive rights for a period of 30 years to provide various facilitation services to be set up by these bodies. The Company has paid one time
fixed fee to the bodies towards such rights. The fee paid is recognised as an intangible asset and accordingly capitalised as ‘Business Commercial Rights’
in the financial statements. The annual income from these bodies is based on fixed fee per customer admitted /enrolled with the bodies during the tenor
of the agreement and is subject to minimum guaranteed amount each year.
Joint Venture agreement
The Company has entered into a joint venture agreement with XXX Builders to construct YYY building. The operations have not commenced
17. Annual Report : 2011-12 – Balance Sheet
• 2 consecutive years of high increase in DTL
• 50% increase in other current liabilities,
check details
• major increase in tangible assets
• so much jump in long term loans? to whom
and why? are they investing in core assets?
• why loan when so much current
investment. from where this money came?
equity or debt?
• so much cash then why loan?
18. Annual Report : 2011-12 – Cash flow statement
• For what purpose, deposits are given?
• What are these investments?
• Why again for loan cash placed to bank
when tangible assets increased so much?
Cash and cash equivalents above includes fixed deposits of ` 409,030,556 (previous year ` 270,000,001) placed with a bank against working capital
loan obtained from them.
19. Annual Report : 2011-12 – Schedules
• 24 crores out of 82 crore asset is spent on office building of KMP? Is it a common practice? Wont renting would have been a
better option?
• 33% of asset is intangible, 33% is office for promoter, 12% is land. Is this asset a productive asset? Also, as we have seen
asset related ratios have not been impressive
• Should not we look into competitive companies and try to compare these things?
20. Annual Report : 2011-12 – Schedules
• Story continues at a larger scale
• Story continues at a larger scale
• Story continues at a larger scale
• Followed by 25% increase in auditor remuneration
21. Annual Report : 2011-12 – Related Party Transactions
• Rent paid gone up by 6 times
• Remuneration doubled
• Advances given to KMP for his office construction
• Investment in Infra company continues
22. So, now in Summary, lets back to all the points
23. Key Points from Quick Financial Analysis
• What is working
o Revenue Growth
o PAT Growth
o Good Liquidity Ratios like debt to equity, quick ratio etc.
• What is not working
o Huge PAT to CFO Mismatch
o Huge CAPEX to PAT leading to very negative FCF
o Highly working capital intensive
o Gradual increase in receivables and increasing debtor days
o Sudden increase in other expenses
o Highly fluctuating expense items
o Low RoE and RoCE
• What needs to be understood in detail
o Why high Gross Asset/Revenue Ratio without any improvement
o Why regularly high CAPEX required without improvement in asset related ratios like asset turnover, return
on assets – accounting and cash
24. Key Points from 2 year Annual Report Analysis
• High rise in loans and advances due to
• Loans given to employees and KMP at 0% interest rate
• Loans given to other companies (non-subsidiary) for infrastructure construction
• Loans given for KMP office building
• Lot of intangible assets added as business commercial rights resulting in –ve FCF
• Lot of assets added in the form of freehold land and office building resulting in –ve FCF
• Cash pledged for working capital loans despite of hard assets
• Auditors were given incremental fee handsomely
• Miscellaneous expenses were significant
• Rental expenses being paid fro KMP increased 6 times
• Management remuneration for some of employees doubled
• What were leasehold rights and means of accounting?
28. Predicting PROBM : Quantitative Value by Tobias E. Carlisle and Wesley R. Gray
29. The Company was TREEHOUSE
Company operating in pre-school business had huge receivables build-ups, any genuine possibility?
Why it needed to pay money to seek exclusive rights to serve?
31. Why company would have been attractive
1. It's a recession proof business
2. Long runway so cash flow if it eventually becomes positive it's ok.
3. Land, Office building etc. will have immense pay off eventually. This is a service not a production business so
asset turnover doesn't really apply in the traditional sense.
4. Debt is very lo and hence comfortable debt to equity
5. Strong revenue and PAT growth rate
6. PE funds are invested
7. Price has fallen from 500 to 67
8. Competitive company has plans to acquire and must have done audit – merger arbitrage opportunity
32. Summary
1. Ignoring CFO compared to PAT
2. Ignoring piling receivables
2. Not reading the AR thoroughly and finding complex/non-ordinary financial management
3. Getting blinded by the price ("fall from 500 to 67, how much low can it go!")
4. Getting blinded by the merger arbitrage
5. Trusting zee and it's auditors ("They must've done their analysis before okaying the merger, right")
6. Not researching the sector and other cos in the sector, etc.
Even though it's a zero debt company in a recession proof sector backed by PE investors, do your homework
(Read AR, as highlighted points on why to invest can make us lazy giving virtual comfort )
34. Structure of an Annual Report
• Performance Highlights
• Shareholder Communication
• Corporate Governance Report - Management, Board, Compensation, AGM outcomes, Dividend, CSR, Policies
• Management Discussion and Analysis
• Standalone Results - Summary and Detail
• Consolidated Results - Summary and Details
35. What to Look for in an Annual Report
1. Understanding of business and company
2. Details of Bankers, Office location and addresses, approvals and certifications, auditors, credit rating - Historic, Current and changes
3. Promoters background, Board Composition and related historic changes
4. Management and board compensation structure and growth : Salary, Fees, Hike, shares, options, warrants
5. Manage Tone - bullish, bearish, over promise, under deliver, hide facts, compared to competitors
6. Financial Details and analysis - Standalone Consolidated - revenue and profitability growth, liquidity, leverage, asset, operational ratios,significant
expense items, standalone to consolidated financial flow
cash conversion and generation ratios, hiding numbers, accounting frauds
7. Corporate Structure - Subsidiaries, holdco etc.
8. Related Party Transactions - Quantum and Rationale
9. Accounting principles - Level of conservatism, Uniformity
10. Management Report card : Does mgmt. makes commitment and does they live upto commitments?
11.Does management highlight risks?
12.Auditor comments
13.Accounting fraud checks
14. Shareholding Structure
36. What to Look for in an Annual Report
Signs of fraudulent/future failure companies to look for in an annual
report:
0. Doubtful means of inflating revenue : % completion method, Capital lease
etc.
1. Revenue vs receivables and days sales outstanding
2. Loan growth
3. PAT to CFO Ratio, FCF/Sales company vs peers
4. Other Items - Income, Expenses
5. One time Expenses
6. Intangible Assets
7. Contingent Liabilities
8. Inter party transactions
9. Re-valuation of assets
10. Change in accounting policy, revenue recognition principle, accounting
principle
11. Interest to Loan Ratio : Interest Rates
12. Cash to Debt Ratio
13. Short term Investments - Where
14. Luxury expense - Other expenses, jets, cars
15. Options, warrants, rights issue, equity dilution
16. Suspension of credit rating - change of rating agency
17. Change of auditor
18. Frequent resignations of key management and board personnel
19. Tax Payments
20. Legal Cases
Signs of fraudulent/future failure companies to look for in an
annual report:
21. ratio change in loans and advances given to debt taken and
reserves and surplus
22. Historical merger and acquisitions and related changes in
financial statements
23. Dubious background of promoter
24. Capitalizing expenses - Check FCF and competitive expense
accounting policy
25. Juggling cash flow items from one section to another
26. Inventory Buildup
27. revaluation of assets which is not justified
28. Too much share price talk and use of buzz words in annual
report
29. Company name and nature of business change history
30. History of promoters opening companies in sectors which is
flavor of season
37. Over the years, Charlie and I have observed many accounting-based frauds of staggering size. Few of the perpetrators have
been punished; many have not even been censured. It has been far safer to steal large sums with pen than small sums
with a gun.
Warren Buffet, 1988 Chairman's Letter