Accounting irregularities: How can investors spot red flags?
In recent times, the Indian startup ecosystem has witnessed a rise in financial fraud, with GoMechanic being the latest addition to the list. BharatPe, Trell, and Zilingo were some of the other startups found guilty of financial fraud. Given that even large private equity and venture capital firms have fallen victim to these scams, it becomes important for individual investors to be vigilant in identifying and spotting financial irregularities. This is crucial in protecting their investments and avoiding financial losses.
Let us try to get a brief understanding of the type of fraud the founders of these companies pulled off.
Trell: The founders were accused of related party transactions, Which simply means that they were doing transactions keeping in mind their interests rather than the companies. Also, several financial irregularities were found.
Zilingo: CEO and Co-founder was accused of inflating the revenues.
BharatPe: BharatPe accused its founder of misappropriation of funds of the company for personal use.
GoMechanic: The founders admitted to inflating revenues and knowingly falsifying figures to investors.
Identifying potential red flags in a company’s financial statement
Let us look at some of the possible financial red flags that might require you to investigate more about the company:
Are the company’s financial results too good to be true?: When analyzing the financial statement of a company, it is important to keep an eye out for anything that seems too good to be true, If the numbers look too perfect or if there’s a sudden boost in performance, it’s worth taking a closer look to see if everything adds up.
Comparing the report to management’s opinion: When analyzing the financial statement of a company, it is important to take a look at the “summary of misstatements” section. This section is found in Auditor’s report. Sometimes, the company’s management might have a different opinion than the auditor, you have to compare the reports and see if any red flags might be hidden in the reports.
Uncovering unusual accounting policies: Sometimes companies use accounting practices that are out of the ordinary. This can make it hard to compare them to other companies. These practices may include overestimating or underestimating assets, improper valuation of inventory, creating reserves, and more.
Detecting changes that signal trouble: When reviewing a company’s financial statements, it’s crucial to keep an eye out for any changes that may indicate potential problems. This can include trends such as an increasing debt-to-equity ratio or large adjustments made late in the year. Additionally, changes in senior management can also have an impact on financial reporting.
Uncovering anomalies in financial statements: When analyzing a company’s financial statements, it’s essential to keep an eye out for any anomalies or numbers that appear unusual. These can include high numbers in the ‘Other Expenses’ category, Be on the lookout for patterns such as a majority of sales in the last few days of the month or quarter, or a sudden surge in the value of fixed assets, as they can indicate potential financial issues.
Uncovering suspicious transactions: When you’re checking out a company’s financials, keep an eye out for any transactions that look a little too complicated or sketchy. These deals might involve internal or external parties and may not have a sound economic basis. Such transactions are often used to deceive you, it’s important to treat it as a red flag and spend some extra time looking into it.
Bonus bait: In some companies, the top-level management gets bonuses based on how well the company is doing. This can make them manipulate the results so that they earn bonuses. it’s essential to be aware of this possible pitfall and evaluate the company.
Rising debtors and inventory: As you review a company’s financial statements, pay attention to the debt and inventory levels. A significant increase in either of these can indicate potential bad debt. it’s important to analyze the reasons behind these changes and understand the impact they can have on the company’s overall financial health.
Gross profit margin increasing but sales are declining: When analyzing a company’s financial performance, it’s important not to be swayed by an increase in profit margins alone. As an investor, it’s essential to look beyond the profit margins and consider the sales figures and overheads to understand the company’s overall financial health.
It’s important to remember that these red flags aren’t necessarily a sign of a company in trouble. Still, they are certainly worth keeping an eye on and investigating further before you invest.
If you’re feeling unsure or have any doubts even after analyzing all these points, it’s always a smart idea to talk to a financial advisor. They can give you extra information and advice to help you make the best decision for your investment.
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Tags: accounting policies in financial staement BharatPe financial advisor Financial fraud Go Mechanic red flags in company's financial statement Zilingo