Forensic Analysis

Cash flow from operations(CFO)/EBITDATo verify if a company indulges in aggressive revenue recognition which may not translate to actual cash.
Year-on-Year volatility in depreciation rateDepreciation, being a non-cash charge, can be used to manipulate the earnings by changing the useful lives of fixed assets. Common depreciation methods are the straight line method(SLM), double declining balance(DDB), and the useful lives method.
Yield on cash & cash equivalentsEquivalent to yield on short term treasury and fixed deposits
Contingent liabilities as a % of Net worthA higher provision indicates the higher risk associated with the nature of the business.
Growth in auditors remuneration to growth in revenuesTo measure the auditor's objectivity in preparing the reports of the company. A faster growth in auditor remuneration is an alarming sign.
Comparative common size income statement vs peers to analyze significant divergence in P&L items vs peersTo familiarise with the nuances in financial statements of a particular industry/sector.
R&D capitalization vs charge to P&LAccounting standards allow companies to defer expenses related to research and development to a later date. This helps the companies to recognise less expense for a particular year and shore up the profits for that year.
Identify the extent to which companies misuse or abuse this
Goodwill as percentage of net worthGoodwill is a plug figure and not an actual cash item to balance the basic accounting equation.Asset = liability + equity.
Frequent change of auditorsCompanies change auditors who are not plaible especially when they have skeletons in the cupboard to hide.
Management credibility is called into question.
Any significant adverse comments in the reportAn unqualified audit opinion is an indicator of a company giving importance to maintaining clean books of accounts.
Quality of audit committeeWhether the audit committee is chaired by an independent director.
Frequent changes in accounting periodsIndicative of short term focus of the company management to meet the street expectation every quarter.
Related party transactions and their significanceA higher proportion of revenues & purchases from related parties may indicate transactions which are more paper based and not actual cash flow generating.
Other business interest of promotersTo check if the promoter is spreading himself thin and unable to give his undivided attention to his core franchise.
M&A with promoter owned entitiesTo offload non core assets to merged entities or merger with entities which are not complementary to the core business. Eg. Satyam Computers proposed merger with Maytas Properties.
LitigationSignificant ongoing litigation involving the promoters or company.
Promoter family structureTo ensure proper succession planning is in place.
Pledge of promoter shareholdingTo check if borrowing by the promoters for their personal indulgences.
Insider buying and sellingInsiders/company have first hand information of the inner working of the company and their trading activity is a leading indicator of potential surprises. Buying is a positive and selling is negative.
Frequency of equity dilutionFrequent equity issuance to raise funds is indicative of a business model unable to generate internal accruals to be able to maintain the ‘going concern’ status.
Is long term return on capital employed(RoCE) greater than cost of capital (CoC)?RoCE is the return the promoter of a company generates for every $ of investment in the business. There should be a spread between RoCE and CoC to keep expanding the market share and moat
RoCE compared to competitors
How prone is the company to a new disruptor?Identify whether the company has a wide moat.
How often does the company disrupt other competitors?Is the company gaining market share from competitors?
Is the company the first amongst the peers to introduce something new ?
What is the importance of R&D and who leads this function in the company ?R&D as a % of revenue
Is there a culture of innovation prevalent in the company?Patents, company sponsored employee training and higher education incentives.
Difference between company’s products and its peers
Any dilution or mudding of brand positioning
Are their advertising campaigns differentiated, do they break through the clutter and convey brand promise
What are talent recruitment strategies ?
Is there a key-man risk/reliance on the promoter ?
How rewarding is it to be a supplier for the company ?
What is the return on investment for a dealer/distributor of the company’s products?
How long has been the relationship between the company and the licensor ?A longer relationship is indicative of a strong partnership
Do the competitive advantage grant the company pricing power in the business
Is the company generating positive operating cash flow and FCF on a consistent basis ?
What is the growth strategy being adopted - market penetration, product development, market development and diversification ?
What is the quantum of capital being allocated towards growth strategy? How much is it as a proportion to net worth ?
Does the growth strategy lead to a substantial increase in financial leverage ?
If growth is pursued in intl markets through acquisitions, what is the management's experience and track record in the geographics ?
Does promoter group have other businesses also if yes what is their ownership of other businesses ?
Are there other investments by the promoter in capital intensive businesses?, if yes, what is the source of capital for those businesses ?
Is there a clear succession plan in all key leadership places ?
Is there evidence of decentralization of power and authority
- both for day to day business execution, as well as for implementing capital allocation decisions ?
What is the quality and tenure of CXOs in the organization ?
What is the longevity of FCF generation ?
Does the company have clean accounts
Does the management have consistent track record of prudent allocation
What is DCF value of the FCF over the long term period assessed


1. Financial Shenanigans by Howard Mark Schilit,
2. Diamonds in the Dust by Saurabh Mukherjea, Rakshit Ranjan, Salil Desai