Investing 101: How to identify a fraud company

The starting point

“Never invest in a company without understanding its finances. The biggest losses in stocks come from companies with poor balance sheets.”

— Peter Lynch

Sun Tzu’s The Art of War, considered the oldest military treatise in the world, makes an incisive observation regarding winners and losers. The victorious general wins first and then goes to war, while the defeated general goes to war first and then seeks to win, Sun Tzu wrote.

In other words, preparation is the secret sauce of success. Nowhere is this truer than the art and science of stock picking.

While most of us make our investment decisions based on screaming news headlines or social media hot tips, the real masters of the game start at the very foundations of corporate finance—a company’s profit and loss (P&L) statement, cash flows and balance sheet.

Put simply, a P&L statement shows how much a company earns and spends in the course of its business during a period of time (usually one quarter). A cash flow statement, as the name suggests, tracks the inflow and outflow of cash. A balance sheet, on the other hand, is a summary of a company’s assets and liabilities at a point in time (usually the end of a financial year).

To understand this in terms of an analogy, suppose you are a salaried individual who maintains a monthly budget for your expenses. The salary is credited to your account at the beginning of the month, and you start paying your grocery bills, EMIs, rent and other charges using this money. Hopefully at the end of the month, you will have some surplus left. This is akin to your P&L and cash flow statement, which gives a pretty accurate idea of the state of your finances.

But your financial report card would be bigger than just what you make and spend every month. You would have assets like real estate, cars and jewellery, as well as investments like stocks, mutual fund holdings, fixed deposits, etc. You could also have home loans, car loans, borrowings from friends and other financial commitments. This compilation of your assets and liabilities represents your balance sheet.

Thanks to the vicissitudes of life, sometimes your expenditure might overshoot your earnings, or you might have to sell some assets to meet some unforeseen obligations. During such periods, your P&L and balance sheet will understandably go for a toss. But generally speaking, over the long run, both the financial statements will move in tandem, and be the most comprehensive indicator of financial health, whether of an individual or a company.

But what happens if some rogue players deliberately distort their accounts to give a misleading impression to others?

Numbers don’t lie

The oldest trick in the book of ‘pump-and-dump’ operators is to create a buzz around a company by announcing a flurry of order wins and alluring topline growth. But most of the good news is only on paper and the rogue firm just increases the revenue figure in its quarterly reports, which is sometimes accompanied by a reduction in expenses, which further juices up the profit.

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So how can investors know whether the numbers are true? The first clue lies in tracking if the taxes reported in the P&L are rising in sync with revenue and sales. While faking revenue, expense and profit figures are relatively easy, falsifying the tax payout is harder due to the interlinked nature of the goods and services tax (GST) value chain. A company’s vendors and suppliers pay taxes based on their supplies and avail input tax credit.

Experts point to the example of Manpasand Beverages, a stock market darling a few years back till it was caught cooking up its books. In an order passed by the Securities and Exchange Board of India (Sebi) last year, the market regulator highlighted how the company faked not just its revenue but also its vendors, customers and suppliers. The house of cards collapsed in 2019 after GST officers raided its premises and arrested its CEO, CFO and a director.

The stock, which had climbed above ₹460 levels in late 2017, lost more than 70% of its value over the next 12 months as skeletons started tumbling out of its closet, before collapsing to about ₹5 in 2019. It was delisted in June 2020.

Sometimes a company does not indulge in outright fraud but gets so creative in accounting that it would make Satyam’s Ramalinga Raju squirm.

The Satyam scandal was one of India’s biggest corporate frauds, with the computer services firm’s chairman, Ramalinga Raju, confessing in 2009 that he had falsified the company’s accounts to the tune of around ₹7,000 crore, inflated the share price and diverted funds to the real estate market.

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“If trade receivables are rising much faster than revenue, it might mean the company is recognizing sales too aggressively or booking revenue without actually receiving the cash,” consultancy firm Corporate Professionals’ founder Pavan Kumar Vijay told Mint.

Trade receivable (or accounts receivable) is the money that is owed to a business by its customers for goods and services that have been delivered but not yet paid for— similar to buying goods on credit from your local shopkeeper.

Another warning sign is any unexplained increase in inventory. “If inventory is piling up without a matching increase in sales, it could mean the company is either overstating its assets or having trouble selling its products,” he added.

If not going the full Manpasand route, many firms also resort to generating fake sales through related-party transactions, which is a prime way to artificially inflate revenue and mislead investors.

Scepticism, so readily dismissed as a nuisance during bull markets, might actually be the strongest armour of a hard-to-con investor.

“If a company’s revenue is growing at a much faster clip than the industry average, then one needs to identify the reason for this overperformance,” Shriram Subramanian, founder and managing director of InGovern Research Services, a proxy advisory firm, said. “For example, if the auto industry is growing at 10-15%, but a company’s revenue is expanding at 30-40%, the investor must look beyond the P&L statements and examine if the firm’s volumes too are growing at a commensurate pace,” he added.

If a company’s revenue is growing at a much faster clip than the industry average, then one needs to identify the reason.
— Shriram Subramanian

Investors who want to dig deeper should also see if profit growth is being reflected in ‘cash flow from operations’ in the cash flow statement.

“It is important to look beyond just profit figures and look at the cash flow statement to see whether a firm’s profitability is emanating from its core operations, how it is using the cash, whether it is buying new fixed assets, etc.,” he added.

Another mischief companies resort to is delaying expense recognition by treating operating costs as capital expenses, which can be a tactic to make profits look higher than they really are.

“Moving expenses to related parties can also be a way to manipulate profits and make the company’s financials look stronger than they actually are,” Corporate Professionals’ Vijay pointed out.

Don’t ask, don’t tell

The next time you see a gorgeous super-luxury car on our pothole-filled roads, use one of the many apps available online to see in whose name the vehicle is registered. In many cases, it will be in the name of a company rather than any individual.

Many SME promoters have this charming habit—treating company funds as their personal bank accounts, and use the former to splurge on themselves and their friends and family.

Thanks to accounting norms, the car will be listed as a “fixed asset” in the company’s books, giving minority shareholders a misplaced sense of security about the firm’s operational health.

“Listing luxury cars, personal real estate, or high-end office décor as fixed assets can be a way to hide personal expenses within the company’s books,” Vijay noted.

Many SME promoters have this charming habit—treating company funds as their personal bank accounts, and use the former to splurge on themselves and their friends and family.

There are myriad other ways through which minority shareholders are taken for a ride by promoters. Case in point—making payments to family-run companies for “consulting” services without any real business contribution or paying themselves and other senior management (most of whom are their family members) excessive salaries, bonuses, and perks despite weak financial performance by the firm.

A cursory reading of many companies’ annual reports will be enough to uncover such gems of corporate governance. Of course, it would be a mistake to confuse passive incompetence with active corruption.

“For example, a high amount of foreign exchange loss in a financial statement of an organization that is a net importer reflects poor risk management strategy from a hedging perspective,” said Vivek Iyer, partner and financial services risk leader, Grant Thornton Bharat.

But in many cases, it can be mighty hard to differentiate between corruption and clumsiness.

Take the case of Varanium Cloud, another high-flying SME company which was barred from the capital markets by Sebi in October 2024 for allegedly syphoning off IPO proceeds, falsifying its book of accounts, share price manipulation and other assorted shenanigans by the promoter.

Varanium claimed to be engaged in services like data centres, distance learning, e-commerce, payment gateway services, among others. (Note the high prevalence of ‘hot’ sectors). It raised about ₹40 crore in an IPO in September 2022 and thereafter kept enticing investors through periodic injections of ‘feel-good’ announcements, including forays into completely unrelated sectors like apparel (apparently in partnership with ‘The Pokemon Company’ of Japan), OTT, jewellery and more.

The entire gravy train was chugging along splendidly but in January last year, the company disclosed that the promoter stake had reduced from more than 60% to about 36%, ringing alarm bells across its investor community, which triggered a probe by Sebi and the exchanges.

Typically, when SME promoters don’t have a skin-in-the-game, it could be a warning sign. A company and its promoters could also be wanting to avoid bank scrutiny by not applying for a bank loan.

Varanium reported a stellar sales expansion, from ₹35 crore in FY22 (pre-IPO) to ₹383 crore the next year and a whopping ₹923 crore in calendar year 2023, along with a matching increase in profit after tax (PAT). Yet curiously, there was no commensurate increase in cash flow from operations. The company clocked a PAT of ₹82 crore in FY23, but cash flow from operations stood at a paltry ₹3 crore.

“A good surrogate for operating cash flow is Ebitda (earnings before interest, taxes, depreciation, and amortization) but for a stable business. For growing businesses, it is important to compare if the trended growth in P&L and cash flow from operations is moving in the same direction to evaluate the sustainability and stability of the business,” Grant Thornton Bharat’s Iyer said.

Varanium’s IPO exercise, too, had a lot of red flags. The company’s red herring prospectus showed it wanted to set up three edge data centers (EDC) in Goa and Maharashtra as well as three digital learning centers, but it was meeting the entire cost of the projects through investors’ money, with almost no contribution from promoters.

Typically, when SME promoters don’t have a skin-in-the-game, it could be a warning sign. A company and its promoters could also be wanting to avoid bank scrutiny by not applying for a bank loan, experts said.

In the case of Varanium, there were also a host of related-party transactions, excessive remuneration to promoters, a high level of pledging of promoters’ shares, and other corporate governance issues, which finally culminated in shareholders learning a very costly lesson. Shares of the company, which were trading at ₹335 levels in January 2023, crashed to about ₹100 by the end of the year and then to ₹20 by the time Sebi’s interim order came in May 2024. The interim order was upheld in October.

Mails sent to Varanium and Manpasand Beverages on the Sebi investigations did not elicit any response. The market regulator’s orders can be challenged at the Securities Appellate Tribunal.

Staying safe

To reiterate an important point, not all cases of P&L and cash flow mismatch should be considered fraud. Some instances can arise out of sectoral disruptions, liquidity issues or just plain inefficiency. But for investors, this would be a distinction without a difference, as the final result in all these cases will be the same—severe erosion of their capital.

Despite multiple examples of well-run smaller companies, there are more than enough listed SMEs where the only creativity and innovation is in their accounting departments. Alas, more fiction has been told (and sold) in Microsoft Excel than Microsoft Word.

The small- and mid-cap stocks can offer lucrative opportunities, but this is one segment where investors who say ‘no’ more frequently have an upper hand over those who impulsively say ‘yes’ to every story.

By following the checklist given here, retail investors can steer clear of disasters-in-waiting lurking in the SME space. As someone wise once remarked, some games are only won by not playing them.