The Ugly Side of Corporate Balance Sheet. “Two most important things in any company, that do not appear in its balance sheet are, its reputation and people” Behind every good businessman, there is a good accountant. Two things that a company’s balance sheet hides through creative number-smith accountants are its reputation and people. A balance sheet symbolises a glossy multicolour booklet embedded with pictures, flashing financial data more like a menu card of a restaurant to soothe the optics than satisfy the inquisitive hunger for the intrinsic kernel of the company. Balance sheet readers get enchanted and captivated in pics of reflected glory. They get lost in the detailed enumeration of sitting fees guzzled by the directors, rather than assimilating the profit brought in by operations or sale of integral assets. Day in day out, various stakeholders are handed out aspirational wish lists couched as balance sheets by symbiotic owners in enviable chutzpah! Off Balance Sheet Plunders
While analysts have long been busy disseminating what is inside the balance sheet, businessmen have been making merry with what is outside. Most of the game is played in diverting funds through off-balance sheet items: mainly non-fund limits, Letters of Credit, Premium earned on forex forward cover transactions routed through undisclosed current accounts, recycling of scrap as freshly purchased raw material, and payment of fake salaries and receivables to in-laws, which no balance sheet can capture. A good balance sheet does not ensure a good customer. A balance sheet reveals the past and the present of the customer but cannot predict the future. Fly by Night Operators
Poet Emily Bronte said,” Riches I hold in light esteem and love I laugh to scorn; Lust of fame is just a dream that vanishes with the morn.” The present generation of enterprising entrepreneurs works exactly the opposite and aspires to be rich and famous overnight. In the lust of money, most get burnt out. It is no wonder that except for the house of TATAs, there are very few corporates left in India, who despite being heavily financed, age more than twenty years of existence. Compare that with Europe and the USA where fifth generations are also thriving as market leaders. Ignoring Cash Flows Over Security
The problem with funding in India is that it is more perceptional than analytical. Bankers get swayed by names. The value of collateral security is more important than the cash flow generation capacity of the company. There is a superficial dissection of financial statements. Banks have spread far and wide but the banking caliber has shrunk at the apex level credit departments who process proposals prepared by field greenhorns, with limited credit ilks. Every aspiring banker must appreciate that a Financial statement is the identity card of the borrower which has to be x-rayed to disrobe the financials threadbare. Four Legs of Financial Statements
Each financial statement is a four part document comprising of the balance sheet, profit and loss account, cash flow statement, and the audit report. Even if one of the four is not given, the proposal should not be touched. The first thing to analyse is the report of the auditor of the company who is privy to tax laws compliance, income tax disputes, statutory defaults, CSR implementations, labour law observances, litigations, and stature of account as a standard or nonperforming asset. Those who read the audit report first regret the least.Pre Sanction Inspection
Before opening the second part of the financial statements, make a visit to the place of business. It is crucial to identify the reputation of borrowers with banks, vendors, staff, and state departments. A brief interaction with the security guard at the factory gate itself reveals the integrity of owners and managers; it may be found that two guards sign four revenue stamps every month with a salary of the third and fourth guard going to the pocket of owners of the factory. Proceeding further, the number of machines installed hardly matches with machines capitalised in the fixed assets register. Rickshaws ply out of factory regularly transporting fresh raw material hidden below the scrap, which is bought back at market rates next morn. The inward stock register at the gate does not carry any proof of goods purchased from vendors being issued big cheques by the accounts department betraying the genuineness of Creditors. No glossy balance sheet captures the true picture of a business. Measuring Skin of Promoters in Business
If auditor report and plant visit permit your heart to proceed further, check the Credit History of stakeholders. First, open the liability side to measure the net worth and skin of the borrower in the business. The subscribed capital should be proportionate to the envisaged loan. The reserves should not be bloated with Revaluation Reserves. Unsecured loans should not be created out of the round tripping of borrowed funds. Account statements of an existing car, housing, business loans from other Banks and NBFCs should also be examined before releasing loans to ascertain timely servicing of EMIs.
Identify Trojan horses among the assets
Dissecting the asset side needs more attention. Is the asset relevant to business? Are there enough Current Assets to meet Current Liabilities? Does the shop floor possess all assets shown in the Fixed Assets Register? Are assets properly depreciated? Are assets insured? Are stocks more than sundry creditors? Are stocks relevant to the production cycle? Is inventory disproportionate to business needs? Are noncurrent assets very high? Are receivables on related parties? Are receivables concentrated on few buyers only? What is the accounting for Intangible Assets? Are Copyrights, Licenses, and Intellectual Property Rights relevant to business? More watchful the Pre-sanction stage, more comfortable becomes the followup. Dissemination Profit & Loss Statement
Decode the components of sale granularly to find whether the same are out of manufacturing or trading. Exclude taxes from total revenue to arrive at genuine sales. Compare the growth with peer level companies. Bonafide Expenses
The expenses should be relevant to business and not be of personal nature. Find whether legal cost and audit fee has gone up disproportionately. Find the amount of depreciation and taxes provided. Purity of Income
Is profit from core activity or sale of assets? Does this income contain Insurance claims, recovery of written off debts, interest income, and dividend received? Compare EBITDA with companies of similar size, to measure the authenticity of income generating capacity. Better the Cash Flow, Longer the Relationship
Cash flow is worked out from the balance sheet and profit and loss statement together. It clearly reflects the capacity of the company to service debt and meet operational expenses. All three forms of activities namely Operating Activity, Financing Activity, and Investing Activity should contribute. Better the cash flow, the longer the life of the company. Balance Sheets have shaped into cosmetic journals hiding more than they reveal. A balance sheet shows the past and present of the company. It does not predict its future. Good balance sheets do not ensure good borrowers who are like pearls in the ocean are found after repeated dips. A financial statement should contain four real non-balance sheet items, namely Honesty, Integrity, Truth, and Trust. Rule of three says, “If you read financial statements three times and still can’t figure out how the Company makes money, that’s for a reason.” Beware of the ugly side of Financial Statements.
hargovindsachdev@gmail.com
About Author
Mr. Hargovind Sachdev is an Ex-Banker, GM(Retd) of State Bank of India. Has over 39 years of experience in banking, having occupied senior positions in UCO Bank, United Bank of India, State Bank of Patiala, State Bank of Travancore & State Bank of India where he headed the Central European Credit Desk at Frankfurt, Germany from 2006 to 2011 covering 15 countries of Central Europe. Has undergone International Banking Training from Asian Institute of Management, Manila, the Philippines in the Year 2003 and a Multi-currency lending-technique training at the Euro Money Institute, London in 2009.
He has specialisation in Credit, Foreign Exchange, Vigilance, Monitoring & appraisal of Corporate Loans, MSME Credit, Gold Loans, Agricultural Loans & NRI Business Management in assets & liabilities. As a Forensic Auditor, he has conducted various Transaction Audits allotted by Banks.
He was felicitated by the Central Vigilance Commissioner, Sh. C.V Chowdhry for winning first prize for best article on Preventive Vigilance in 2015. He is also an accomplished Public Speaker having conducted multiple Motivational Seminars for institutions like ONGC, the National Housing Bank & the Bank of Baroda. He is an Independent Director & consultant to various big entities in the corporate sector at present.
