Deep dive for investors: why cash is king again in a new era of accounting risk

The quality of accounting has changed for Indian companies, especially those with access to public markets. Historically, accounting irregularities have been characterized by excessive debt and theft (excessive capital expenditures or acquisitions). However, corporate balance sheets have shown significant strengthening. The median net debt-to-equity ratio of highly leveraged companies (top 10 percentile) fell by about 61% between FY15 and FY24, to 0.7. On a median basis for BSE500 companies (excluding BFSI), the net debt to equity ratio has turned negative, indicating net cash flow. Moreover, a rising percentage of liquid assets indicates greater caution in capital allocation, moving away from past risks associated with misdirected spending. While the risk of traditional issues such as theft has seemingly diminished, there has been a shift, moving the main focus to the quality of reported profits. The reduction in apparent balance sheet stress was accompanied by ample liquidity, subtly changing the nature of financial risk.

This abundance of capital has seemingly created an environment in which different accounting practices can emerge, primarily focused on reporting strong earnings growth. This phenomenon is especially noticeable around initial public offerings (IPOs). A survey of IPOs since FY13 shows that revenue and EBITDA growth typically peaks in the year of or immediately preceding the listing date. This increased reported performance often coincides with a period when cash conversion efficiency appears to be at its weakest.

The metric used to measure this is the pre-tax cash flow from operations (CFO) to EBITDA ratio. A low ratio indicates that reported profits are not realized entirely in cash, a potential indicator of aggressive revenue recognition. For recent IPOs (CY21-CY24), the median cash conversion was approximately 65%, lower than the 89% observed in previous IPOs (CY13-CY20). Alongside this trend, transparency issues remain, especially when it comes to related party trading. Of the recently filed initial public offering documents (DRHPs), 40% of companies showed gross cash outflows of more than 5% of FY24 revenues to promoter-owned entities. These transactions are directly related to weaker accounting quality and highlight an area that requires special attention.

Given these subtle shifts in reporting focus, the key question for market participants is how to effectively assess the financial health of companies when traditional balance sheet vulnerabilities have diminished and the risk lies in potentially aggressive earnings numbers. Relying solely on high reported growth and profitability figures may not be sufficient for a comprehensive risk assessment.

The challenge is compounded by the fact that smaller companies, which often come to market through IPOs, tend to score lower in accounting quality and face specific pressures related to cash-based ratios. In addition, investors should consider the fact that, after the year of listing (year ‘L’), the growth rate for IPO companies often declines significantly, which is in stark contrast to the pre-listing period. To effectively navigate this market, we must focus on fundamental controls that assess the veracity of reported performance and the quality of corporate governance structures. To address this, market participants must adopt a targeted and tailor-made approach. The most important indicator is the Cash Conversion Ratio (CFO/EBITDA before taxes); a level significantly below 100% warrants careful examination because it suggests a discrepancy between profits and actual cash realization. Second, special attention should be paid to related party transactions (RPTs). Outflows to promoter-owned entities as a percentage of turnover should be monitored as figures around or above 5% represent prominent governance risk. Third, monitoring trends in working capital days is necessary; a noticeable increase in inventory or accounts receivable days that accompanies reported sales growth often indicates inefficient sales or aggressive booking practices. Finally, while regulatory actions have led to many companies switching auditors, investors should assess the quality of the audit function. Differences in accountants’ fees relative to income levels may indicate potential problems with the accountant’s independence or due diligence. By prioritizing these cash flow, transaction integrity and audit quality controls, market observers can gain a better perspective on the true essence of business performance in a high liquidity environment.(The author is Research Analyst – Forensic Accounting, Ambit Capital)

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