According to Ambit, if the BSE-500 is divided into deciles on the basis of accounting quality, the best decile, that is the 50 stocks with the highest accounting standards, has historically offered 26 per cent higher returns a year than the worst decile, that is the 50 stocks with the poorest standards.
In a book (Gurus of Chaos), Mukherjea discusses this. Ambit uses a mixture of qualitative measures and quantitative ratios to judge accounting quality. The qualitative measures involve checking if the management of a given company has a history of involvement in scams and scandals. The auditor and its reputation, its other accounts, prior experience, etc., are also examined along. So is the quantum of the audit fees and non-audit fees paid (if any) - these should also be in line with peers.
Apart from this qualitative assessment, the book discusses two key ratios involving cash-flow statements, and loans and advances. The focus on Loans and Advances (L&A) is easily understood. Most Indian business houses run a combination of listed and unlisted businesses. Frequent L&A between listed and unlisted companies is very common.
If the L&A is consistently at a high percentage of shareholders' equity (equity plus reserves net of revaluation), the promoter might be siphoning cash from listed businesses.
Decoding cash-flow based ratios is a more sophisticated exercise. Mukherjea discusses two important ratios for cash-flow. One is the operating cash flow to operating profits ratio and the other is the cash tax paid as a percentage of book profits before tax (PBT). These are key to "dressing up" accounts.
The operating cash-flow (CFO) to operating profits (Ebitda) is called the Cash-Conversion Ratio. Ebitda is tracked by everybody. It may be the single-most popular measure of corporate health. So, there is always a temptation to inflate Ebitda.
One way to check if such inflation is happening, is to see how much operating cash flow is converted to Ebitda and compare that ratio to peers, averaged out over several fiscals. If the Ebitda is very high, and the cash conversion ratio is low, the company may be in the habit of over-stating profits.
Another interesting ratio based on cash flow is the cash tax paid, compared to the book profits before tax. The cash flow statement delineates the actual tax outgo. This may vary significantly from the "book" tax shown on the P&L account. It is possible for a company to be "zero-tax" according to the IT Act, while showing book profits. The Minimum Alternate Tax was in fact, introduced to ensure that companies paid some tax even if they exploited this.
Over time, Mukherjea suggests that cash tax outgo as a percentage of PBT should be averaging out at reasonably close to corporate tax rates. That is, given a corporate tax rate of 34 per cent, the cash tax outgo should be say, 25-30 percent of the PBT. If tax outgo is a lot lower as a percentage of PBT, there may be a tendency to inflate profits (unless there is a specific rebate). At any rate, the investor should investigate a low tax outgo to PBT ratio.
Looking at a balance sheet, P&L and cash flow statement in this fashion will red-flag some of the more common tricks of creative accounting. It is possible to produce misleading cash flow statements of course. But it is more difficult and therefore, a less common practice. One can use these methods as a filter to build a primary list of "honest" companies.
The author is a technical and equity analyst