Forensic Analysis - Financial Soldier Series Part-2 Article-1

FORENSIC ANALYSIS BASICS

Continuing with our series,

After completing Part-I of our series, we move forward to Part-II of our series: Forensic Analysis. In this article, some basics about forensics are discussed:

PREAMBLE

Fraud is a burning problem all over the world, not only for India. Enron, WorldCom, Satyam are some of the famous fraud cases you might have heard. Up till fraud is uncovered after it occurred i.e. detection of fraud and being damage is already done thereby money already lost. But now the focus is shifting from detection to prevention approach thereby mitigating risk through various means like there are analytical tools available in the market which can be used directly to find suspicious transactions.

RELATIONSHIP OF FRAUDSTER AND ANTI-FRAUDSTER

Remember one thing: “If you want to find fraud then you need to think like fraudster”. Even though after so much of the development in the Forensic sector but still fraud occurs and will be! Because something can be used, can be misused also. There is always a reaction to action. If you find something new to prevent and detect fraud, then it is very obvious that fraudster will find new ways to fraud. But in between trade-off point lies whereby even if you cannot eliminate fully but can minimize fraud and its damage. That’s why I call it as “Never Ending Chor-Police game”.

WORLDWIDE LOSS DUE TO FRAUD

Total loss caused by the cases covered in the study by ACFE (Association of Certified Fraud Examiners) exceeded $6.3 billion, with an average loss per case of $2.7 billion. In 94.5% of the cases in our study, the perpetrator took some efforts to conceal the fraud. The most common concealment methods were Creating and Altering physical documents. And the most common detection method was tips (39.1% of Cases).

(Source: acfe.com, Pg.4 of Report to the nations – 2016 Global Fraud Study)

Geographical distribution of such fraud cases:

(Source: acfe.com, Pg.7 of Report to the nations – 2016 Global Fraud Study)

INDIA’S NPA POSITION

When it comes to India, a recent example is Mr. Vijay Mallya who ran away with banker’s money. NPA is one of the major burning issues in the present economy. RBI came up with various “SCHEMES” (satire intended) like CDR, SDR, S4A and 5/25 etc. But the question comes to my mind: how many Vijay Mallyas are still there in Indian economy who are still undercover. There is no definite answer to this question but have a look at Gross Advances and Gross NPA movement of Indian banking system over a period of time which highlights some interesting facts.

Gross Advances and Gross NPA & Loan Subject to Restructuring and Corporate Debt Restructured movement over a period of time of Indian Banking System (Source: RBI) : Amount in Million
Year	Gross Advances	Gross NPA	Gross NPA %	Incremental Gross NPA %	Incremental Advances	Incremental NPA	% of Slippage NPA to Advances	Loans Subjected to Restructuring	Corporate Debt Restructured	Adjusted Total	Adjusted %
	A	B	C=A/B	D=(Bt/B(t-1)-1)/100	E=At/A(t-1)-1	F=Bt/B(t-1)-1	G=F/E*100	H	I	J=B+H+I	K=J/A*100
2006	1,54,57,301	5,17,531	3.35	-	-	-	-	62,375	48,027	6,27,933	4.06%
2007	2,00,74,130	5,05,170	2.52	-2.39%	46,16,829	12,361	-0.27%	87,326	16,237	6,08,733	3.03%
2008	2,50,34,310	5,66,060	2.26	12.05%	49,60,180	60,890	1.23%	1,54,300	30,144	7,50,503	3.00%
2009	3,02,46,518	6,99,537	2.31	23.58%	52,12,208	1,33,477	2.56%	7,05,952	50,070	14,55,559	4.81%
2010	3,26,20,788	8,17,181	2.51	16.82%	23,74,270	1,17,644	4.95%	9,44,515	1,96,036	19,57,733	6.00%
2011	3,99,59,815	9,39,969	2.35	15.03%	73,39,027	1,22,788	1.67%	5,43,829	1,23,339	16,07,138	4.02%
2012	4,64,88,078	13,69,683	2.95	45.72%	65,28,263	4,29,714	6.58%	12,05,398	3,62,770	29,37,852	6.32%
2013	5,97,18,199	19,27,688	3.23	40.74%	1,32,30,121	5,58,005	4.22%	24,06,045	10,10,806	53,44,540	8.95%
2014	6,87,57,479	26,30,152	3.83	36.44%	90,39,280	7,02,464	7.77%	25,50,661	16,08,616	67,89,429	9.87%
2015	7,56,06,658	32,29,161	4.27	22.77%	68,49,179	5,99,010	8.75%	31,78,788	20,67,303	84,75,253	11.21%
2016	8,16,73,445	61,16,074	7.49	89.40%	60,66,787	28,86,913	47.59%	26,42,720	17,79,490	1,05,38,285	12.90%

From above table, it can be clearly seen that average increase percentage in NPA in last 3 years is around 50%. Further fresh slippage of NPA in 2016 is as high as around 48% as against total advances disbursed during the year. But this is not the end, by so-called SCHEMES, various amounts were restructured over a period of time. If we take into consider loan subjected to restructuring and Corporate Debt restructured, then adjusted percentage is around 10-11% for last 3 years.

Interesting Fact – Underreporting of NPAs by banks

Leading Private sector banks had underreported their NPAs in FY16. Total amount under-reported by Axis, ICICI and Yes comes to more than Rs 18000 Cr in FY16 as identified by RBI. Refer below image extract for more detail:

(Source: https://thewire.in/138498/auditor-extraordinaire-the-curious-case-of-npa-underreporting-in-india/)

Note: NPAs do not mean that they are fully due to fraud but there may be a possibility of fraud behind NPA.

 

NPA was just a one of the thing. There are various occupational frauds, forgeries, Corruption, and bribery etc. occurring in India of which size of fraud is not known. There is a list of frauds whose count is in trillions and quadrillions. One may refer state finances report by Comptroller and Auditor General of India (better known as CAG)

One more interesting and Eye-opener fact:

Refer Article by Indian Express on “A third of top 500 firms books dodgy” dated April 10, 2015.

http://indianexpress.com/article/business/a-third-of-top-500-firms-books-dodgy/

A small Excerpt but much relevant!!! From above article

“The report also states that audit by four big firms of these 500 companies is not necessarily superior to that of home-grown auditors to catch these aberrations. A top revenue department official told The Indian Express they are also studying the report and have commissioned an agency to examine the revenue angle further.

‘Questionable operational practice’ followed by many companies also include those on depreciation, interest cost, employee cost and selling and distribution expenses besides their tax scores as shown in their financial statements.

There are significant numbers of black sheep in the BSE 100 list too. While it does not offer any details, an independent source, analyzing the financial statement, notes that the total number of such companies is above 15.”

DEVELOPMENT IN FORENSIC SECTOR

Various developments are taking place in this field like

-          RBI has mandated Forensic audit need to be done before approving CDR package of borrower

-          Increased reporting requirements by auditors under Companies Act 2013 viz. ICR and ICFR,

-          Increase in the number of players in this field, which dictates demand, and need of the hour.

-   SFIO (Serious Fraud Investigation Office) who comes under Ministry of Corporate Affairs is developing EWS (Early Warning Signal) which will help in early detection of corporate frauds and safeguard gullible investors from fly-by-night operators.

Recently, the government has deregistered more than 2 lac companies and more than 3 lac directors were disqualified.

(Source: https://timesofindia.indiatimes.com/india/centre-disqualifies-over-2-lakh-directors-of-shell-companies-within-15-days/articleshow/60927911.cms)

Further, the government also identified a list of entities wherein extra-ordinary deposits made during the demonetization period. A government investigation has revealed that Rs17,000 crore was deposited into 58,000 bank accounts and withdrawn after demonetization, pointing to tax evasion and money laundering.

(Source: http://www.livemint.com/Companies/g3KUovJaafYFKbxaUIivJP/Shell-companies-Govt-identifies-Rs17000-crore-of-suspiciou.html)

Securities and Exchange Board of India, esteemed regulatory authority also indirectly contributing to this field. One may refer to various orders passed by SEBI in respect of Share price rigging, various statutory violation by listed entities wherein they have worked remarkably and uncovered malpractices of share price rigging.

Be connected to upcoming articles…

Forensic Analysis - Methods of Financial Analysis

Continuing with our series,

Article-1 Basics of Financial Analysis

Article-2 Basics of Understanding Business and Industry

Article-3 SWOT Matrix as a tool for understanding business

Article-4 PESTEL Matrix as a tool for understanding business

Article-5 PORTER'S Five forces as a tool for understanding business

In last articles, about business and industry analysis discussed. In this article, we are switching to quantitative aspect of financial analysis. There are four commonly known methods for financial statement analysis.

METHODS OF FINANCIAL STATEMENT ANALYSIS

ü  Horizontal analysis (Trend analysis)

ü  Vertical analysis (Common Size analysis)

ü  Ratio analysis

ü  Peer comparison

HORIZONTAL ANALYSIS

The simplest way of doing analysis, a base year is select then later year or years figures are compared against that i.e. relative changes happened over a period of time.

For example,

Particulars	2013	2014	2015	2016	2017
Sales	10,000	12,000	12,800	14,000	15,980
Cost of goods	7,000	8,500	9,300	10,450	11,500
Gross Profit	3,000	3,500	3,500	3,550	4,480
Employee Benefit Expenses	1,500	1,980	2,100	2,200	2,500
Manufacturing Expenses	500	680	700	480	605
Other Expenses	300	350	240	110	400
Net Profit	700	490	460	760	975
Sales	-	20.0%	28.0%	40.0%	59.8%
Cost of goods	-	21.4%	32.9%	49.3%	64.3%
Gross Profit	-	16.7%	16.7%	18.3%	49.3%
Employee Benefit Expenses	-	32.0%	40.0%	46.7%	66.7%
Manufacturing Expenses	-	36.0%	40.0%	-4.0%	21.0%
Other Expenses	-	16.7%	-20.0%	-63.3%	33.3%
Net Profit	-	-30.0%	-34.3%	8.6%	39.3%

In above example, 2013 is a base year and later year figures are converted based on that year. In 2014, Sales grew by 20% but gross profit grown by 17% only. Possible reasons for deviation may be Sales has grown in absolute value but per unit realization decreased, cost of goods increased either there is an increase in price per unit of consumption or there is the increase in consumption at a constant price per unit production i.e. production efficiency increased. Same can be analyzed for other years as well

Drawbacks of using this method

ü  Selection of base year is very critical to analysis since all later years figures are translated into base year figure.

ü  This analysis throws just changes in numbers, it failed to include qualitative factors i.e. Industry policy changes, taxation and legal policy changes etc.

ü  It failed to include the impact of internal material events of the organization like changes in management, new product line introduced etc.

This method may be useful if there are no material changes occurring during tenure under analysis. Business is running on the constant assumption for various factors. Various ratios are can also be calculated as previous year as a base for the current year, for example, increase in sales YoY.

VERTICAL ANALYSIS

In this type of analysis, various line items are shown as Percentage of one common variable for every year.

Like, for balance sheet – Total Assets will be taken as a base and then after all line items will be converted to a percentage of Total Assets. For-Profit Loss – Generally Sales is taken as the base figure then all expenses are considered as a percentage of Total sales figure.

Example

Given below is an example of the Balance sheet, the same can be applied to Profit-Loss Account as well.

Balance Sheet	2015	2016	2017
Equity & Liabilities
Equity & Reserves	2000	2300	4800
%	20.00%	14.74%	21.82%
Total Debt	4000	4156	7893
%	40.00%	26.64%	35.88%
Total external Liabilities	4000	9144	9307
%	40.00%	58.62%	42.30%
Total	10000	15600	22000
%	100	100	100
Assets
Fixed Assets	3000	3589	5932
%	30.00%	23.01%	26.96%
Investments	2300	2648	3596
%	23.00%	16.97%	16.35%
Total other assets	4700	9363	12472
%	47.00%	60.02%	56.69%
Total	10000	15600	22000
%	100	100	100

In above example, all figures are converted in percentage for given year’s total figure. If you see total external liabilities other than debt was 40% in 2015 then rose to 59% in 2016 then again reached to nearby 40% i.e. 42% in 2017, while total other assets were 47% in 2015, rose to 60% in 2016 then declined to 57% in 2017. Here it is important to note that even though external liabilities declined to 42% from 59% in 2017 but other assets still nearby 60% i.e. 57% in 2017. One possible reason can be funded are blocked in Trade receivables and Inventories or reduced payment days for Trade creditors. One need to find reasons for the same why the entity is not able to collect payment in time but started paying creditors in reduced time.

Drawbacks of using this method

ü  This analysis throws just changes in numbers, it failed to include qualitative factors i.e. Industry policy changes, taxation and legal policy changes etc. But somewhat you can rely on if you compare with other peers entities.

ü  It failed to include the impact of internal material events of the organization like changes in management, new product line introduced etc.

ü  Different entities carry different business models.

This method is especially useful for analyzing relative changes between two accounting periods. Despite its limitation, you can compare target entities’ proportion to that of all other entities in Industries. Exceptions need to be investigated. (Which covered in Peer comparison)

RATIO ANALYSIS

Ratio analysis is used to evaluate various aspects of a company’s operating and financial performance such as its efficiency, liquidity, profitability, and solvency. The trend of these ratios over time is studied to check whether they are improving or deteriorating. Ratios are also compared across different companies in the same sector to see how they stack up, and to get an idea of comparative valuations. Ratio analysis is a cornerstone of fundamental analysis. (Source: Investopedia)

Since it is a basic concept so it is not discussed in detail and numerous material available on the web for ratio analysis. Nevertheless, remember, interpretation is a key to ratio analysis. Ratio analysis alone will not help rather it must be always interpreted in the context of another variable. Further, there is no benchmark for any ratio since each industry has unique standards for various ratios.

E.g., Say Profitability ratio of a particular year got affected then one of the reason could be said increase in tax rates and entity is not able to pass on the increased cost to end consumer being the highly competitive market. Here, decrease in profitability ratio alone will not help to understand the reason why rather it needs to look upon with Policy changes industry-wide.

Ratios are majorly expressed In following Forms:

In percentage – E.g. Various profitability ratios like Net profit or Gross profit 25% or 5.15% etc.

In Proportion – E.g. Debt Equity ratio expressed as 2:1 or 3.5:1 etc.

In times (pure number) – E.g. Fixed Turnover or total asset turnover ratio expressed as 5 or 9.8 times etc.

In period – E.g. Trade receivable and Trade payable days as 90 days or 180 days etc.

BROAD BIFURCATION OF RATIOS:

Liquidity Ratios

-          Current ratio

-          Quick or Acid test ratio

-          Cash Ratio

Operating Ratios (including Profitability ratios)

-          Gross Profit ratio

-          Operating ratio

-          Expense ratio

-          Net profit ratio

-          Stock Turnover ratio

-          Fixed Turnover ratio

-          Debtor Turnover ratio

-          Total Assets Turnover ratio

-          Return on Equity

-          Return on Capital Employed

Leverage Ratios

-          Debt to Equity ratio

-          Debt to total assets ratio

-          Interest coverage ratio

Valuation Ratios

-          Price-Earnings (P/E) ratio

-          PEG (PE Growth) ratio

-          Market Value to Book Value ratio

-          EV/EBITDA ratio

-          Market Value to Sales ratio

-          Market Value to Cash Flow ratio

Example: You can refer below link for better understanding with the detailed case study.

https://www.atozinbanking.com/index.php/study-material-on-banking/83-financial-ratio-analysis-with-case-study

Limitation of Ratio Analysis

-          One cannot use Ratio in absolute terms. It is always to be used relatively.

PEER COMPARISON (Extension of Ratio Analysis)

Peer Comparison is not a unique method of analysis rather it is the mixture of above three methods. In these methods, one entity is compared with another entity in same/similar industry or against the benchmark of Industry as a whole. Based on peer comparison, one may find the deviation from Industry practices and need to find out reasons for such deviation.

One of the best sources is “Screener.in” wherein you can find readily available ratios for listed entities, and customize other entities ratios by adding various columns. (Will also write guide on how to use screener more effectively if time permits)

Be connected to upcoming articles…