Financial Gimmickry: Essential Steps to Protect Your Investments

"Financial gimmickry" typically refers to deceptive or fraudulent activities conducted to manipulate financial data or statements has been key concern for the investors. From creative accounting to intentional frauds, the landscape of financial manipulation is huge. Understanding the various form of financial gimmicks is important to safeguarding investments.

Although detecting financial shenanigans can be challenging and it's essential to conduct your analysis with objectivity and diligence. Here are some steps you can take to detect potential financial manipulation.

1) Comparing cumulative CFO (Cash Flow from Operations) and cumulative PAT (Profit After Tax)

A company that sells any product today might not receive its payment immediately. Since the sales are accrued its profitability is reflected in profit and loss A/c. However, the money received from buyer will be reflected in CFO only when the money is received from the buyer.

When a company’s cumulative Cash from operations over the period, let say 10 years significantly differs from cumulative profit after tax over 10 years then it should raise flags.

If cumulative PAT is in the similar range to cumulative CFO, it means that the company is able to collect its profits in actual cash from its buyers. If CFO is considerably lower than PAT, it would mean that either the company though legitimately eligible to receive money from buyer, is not able to collect it or the profits are not real. In either case, the investor should get alert and should do further analysis of the company. For example, comparing it with peers in the same industry.

2) Using Free Cash Flow instead of Cash flow from operation

Many companies try to inflate CFO by capitalizing on day-to-day operating expenses. With this financial gimmick, not only company’s profitability will be inflated it will elevate CFO too, as capex expenses are accounted as investing expense rather than operating expense.

It might be difficult to identify such accounting tricks, therefore for cash flow analysis you should rely more on Free Cash Flow metric than Cash from operation for better understanding.

FCF can be calculated by subtracting capital expenditure(capex) from CFO.

FCF = CFO – Capex

3) Analyse any Major change in accounting policy introduced by the company.

A major change in accounting policy can be strong indication of a red flag if it appears to be motivated by a desire to manipulate financial results rather than enhancing transparency in accounting standards or practices. Here are scenarios while policy changes would possibly cause extreme concerns:

i)?Impact on Key Metrics: Assess the impact of the policy change on key financial metrics such as revenue, fees, earnings, and cash flow. Significant fluctuations in these metrics following a change in policy may require further analysis.

ii)?Impact on Future periods: If the change artificially elevates current earnings at the expense of future periods or creates hidden liabilities, it could be indicative of financial manipulation.

iii)?Disclosure Quality - Lack of enough disclosure or vague explanations may indicate an attempt to hide the true reasons behind the change.

iv)?Auditor Qualification - Pay attention to any commentary or qualifications furnished by the company's statutory auditors regarding the accounting policy change. Auditors may raise concerns or provide insights into the changes in accounting.

Although, while changes in accounting policy are not presumed to be suspicious, investors and analysts should exercise caution and conduct due diligence when evaluating the implications of such changes on a company's financial reporting and performance.

4) Analyse if Management is Misrepresenting any financial Metrics

Sometimes, managers engaged in manipulation to alter numbers required values in the financial statements and make them depict improved performance or financial position. It is hence crucial for investor to undertake a proper analysis of management intention as suggested. Given below are few examples of the same:

i.?EBITA: EBITDA is one of the favorite methods to determine the company’s operating profit capability, excluding some costs. For instance, while calculating it, management may leave out some charges, which otherwise could have reduced the EBITDA greatly or may use some accounting techniques that will make the earnings look more appealing than they are in reality. Another suggestion could be profit after tax as a better metric that would help in comprehending an entity’s performance in general.

ii.?Adjusted Earnings: Management can also provide direction on reported profits by adopting some techniques such as using the concept of extraordinary items, which allows the company to exclude specific items that are not recurrent in its operations. Although such changes may be warranted at times, over- or improper- adjustments may skew up the earnings and create mis-suggestions regarding the actual profitability of the company.

iii.?Customer Metrics: This issue can be observed when other key performance indicators such as customer satisfaction, customer retention or customer engagement are used cover up poor financial performance. However, customer metrics are still valuable when establishing an overall state of a business, and should be paired with financial metrics of the firm.

Earnings management is commonly found in companies where management uses one or more financial manipulations in an attempt to either focus on a set of desirable financial measures while ignoring less favorable measures, or misrepresent the financial performance of the firm. The potential investors and other stakeholders should not be easily convinced by the fraudsters, but should always avoid taking decisions based on fake numbers and should also do proper analysis of the companies management figures.

5) Analysing Complex related party transaction

There is no issue with related party transactions in the normal course, however they become useful when engaging in corporate fraud or account manipulation. Here's how they may be cooked: Here's how they may be cooked:

i)?Circular Transaction: Circular transactions refer to a chain of transactions among related parties that are devoid of economic reality, meaning that there are no benefits accruing from the transactions. For instance: a company may sell some of its assets to a third party who in turn sells them to another related company or sells back to the selling company at a price which is way above the actual market prices; the aim being to create an impression of a genuine transaction which in real sense inflates the revenues or the assets respectively.

ii)?Non -Arm Length Transactions: To eliminate bias, it is expected that related party transactions should be done at an arm’s length; this is to mean that the prices at which the related parties transact should be the same as those that would be charged if the parties are strangers to each other out for self gain. Nonetheless, insiders may exploit their inside information, position and power for their benefit in order to negotiate more beneficial terms and conditions from related parties, thereby making the transactions unfair and inequitable.

In this case, related party transactions should also be closely monitored to avoid allegories of SEBI, and other regulatory bodies.

6) Tracking Aggressive Acquisitions

Acquisitions are another favorite area that the management dislikes and abuse due to regularly complexities and aggressive accounting practices.

• Overpaying for Acquisitions: By overpaying, especially in an attempt to use what was considered a strong indicator of value, goodwill on the balance sheet can be noticeably increased. The foundational metric of acquisition goodwill is the amount of premium over the fair value of the company being acquired. Inflating goodwill make the company seem more valuable as it may not be I reality. An investor should also determine if these acquisitions are normal for the particular industry because it is always prudent to be wise when investing.
• Financial Engineering: There are several reasons for why companies might enter into a variety of complex and more than often difficult to understand financial structures in order to minimize or otherwise influence the consequences of acquisitions. This could entail the use of debt, off balance sheet financing, or derivatives.

To sum up, acquisitions can be understood as perfectly legitimate mechanisms of strategic growth, yet both consistent acquisitions and unsupported by substance financial juggling disrupt the ethos of shareholder value and destabilise trust in a company. Analysing the financials of organizations that are involved engage in active acquisitions is the only way to avoid compromise.

Conclusion

Conducting thorough due diligence, scrutinizing management's explanations and disclosures, and assessing the integrity of corporate governance structures are crucial steps in uncovering potential financial irregularities. By taking proactive measures, stakeholders can help safeguard financial markets, protect investors, and promote sustainable long-term value creation.

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