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Look for warning signs in stocks

Keeping an eye on some key financial parameters can protect investors against rude shocks.

At times, stock market investors get hit badly. Investors in Prakash Industries and Bhushan Steel experienced this pain recently when both stocks tanked after the bribery scandal involving the chief of Syndicate Bank, SK Jain, came to light. He has been accused of receiving bribes worth `50 lakh to enhance the credit limits of these two firms. While Prakash Industries's shares slipped 38% in the past two weeks, Bhushan Steel has tanked by 60%. In the case of the latter, there was no exit route available for investors as the stock froze on the lower circuit with no buyers. But did investors ignore the red flags? While Bhushan Steel's fundamentals were visibly deteriorating, Prakash Industries's corporate governance practices were already in question, having been named in the coal scam. There are several red flags investors need to watch out for to avoid getting into hazardous stocks. High debt to equity ratio As with individuals, firms that borrow beyond their means live on the edge. As long as cash flows are enough to cover the obligations, a high level of debt may not weigh heavy on a firm's financials. But the moment its earnings start to wobble, it is game over. Resorting to heavy borrowings when profits are not keeping pace, it is a sure fire recipe for disaster." As on 31 March, 2014, Bhushan Steel was staring at `40,000 crore in outstanding loans. At nearly 3.5-times equity, its leverage was clearly on the higher side. What compounded the problem was the firm's progressively deteriorating fundamentals. While its interest outgo climbed from `446 crore in 2011 to `1,663 crore in 2014, its profits dwindled from `1,005 crore to `62 crore during this period. Another telling statistic was the rising pro portion of debtors in the company's revenue. The company's debtors rose from around 7% of revenues in 2010-11 to a staggering 22% in 2012-13, indicating that it was selling more on credit and not actually realising cash. Faced with a tight situation, it had to resort to more borrowings to avoid defaulting on existing obligations. Investors should avoid companies that take on increasing level of lever age, as indicated by the debt-equity ratio. Al though a company's borrowings should be seen in the context of its capex and growth trajectory, it should be able to maintain a threshold level of debt-equity ratio. A debt-equity ratio higher than 3 should be seen as a red flag. Also, keep an eye on the interest coverage ratio of the company, which indicates its ability to meet its interest payments. A decreasing interest coverage ratio is not a healthy sign for a business. Ideally, the company should maintain an interest coverage of at least four-times the interest outgo. Pledging of shares Often, promoters pledge a part of their holding in the company as part of an arrangement with lenders to meet working capital needs or some other requirement of the company. This in itself is not a reason to worry about its prospects. However, pledging can be a problem in some cases. Companies with a high proportion of pledged promoter holdings are highly susceptible to share price erosion, particularly in a falling market scenario. If the share price falls below a certain limit, the promoter is required to provide additional securities or make additional payment. The lender holds the right to sell the pledged shares in case the promoter defaults on his repayment. This may lead to a sharp fall in share prices. Pledging by promoters is not a problem if the company can absorb the debt and has healthy interest coverage. But, if the company is already leveraged to the hilt, there is a chance of a default which may invite a sell-off of the pledged shares For instance, after Kingfisher Airlines failed to repay its loans, State Bank of India, in April 2013, sold shares of United Spirits and Mangalore Chemicals and Fertilisers that were pledged to them by the promoter, Vijay Mallya, against money lent to the carrier. Investors need to know the purpose for which the pledging is done. If the pledging is done to create value for the company, then it is not a problem. However, it is not a healthy sign if it is for promoters' personal reasons like investing in some other business, personal needs, etc. In some cases, higher pledging by the promoter may also indicate weak financial health of the company. Cash burn Investors are known to give a lot of importance to the growth rate of a company, whether in terms of sales growth or profit growth. At the end of the day, however, it is important that this translates into cash generation for the company. Otherwise, the company is treading on thin ice. For instance, a firm may be reporting high revenues, but they will only be meaningful if the firm is able to turn them into cash immediately. If a firm's cash flows are not growing in line with its revenues, it's a worrisome sign. The firm's operations may actually be burning cash, despite higher revenues. If a chunk of its sales are on credit, irrespective of its revenues, the firm may have to resort to borrowing just to keep the lights on.

This is clearly evident from Bhushan Steel's financials. Over the past four years, the company has reported a continuous growth in revenues, which belies its real state of affairs. A look at the cash flow statement shows that its operating cash flows have been highly erratic and inconsistent with the growth in revenues. Murarka insists that investors should look closely at a company's cash flow to get a better sense of its position. It is possible for a firm to overbook revenues or under-book certain expenses to dress up its financials. But it cannot tinker with cash flows, which reveal the true picture of its health The cash flow index, calculated by dividing the cash from operations by sales, can be used to gauge the cash generation ability of a company. If this ratio is consistently deteriorating, it is a red flag.

Investors may also look at the company's working capital position, as represented by the receivables (debtors) and payables (creditors).The receivables days ratio shows how many days it takes a firm to realise cash from its debtors. If the number is progressively increasing, it is a red flag. Gupta explains, "If receivables are continuously increasing, it means that the company is booking revenues without accompanying cash flow. Simultaneously, if the company's payables days are coming down year after year, then the company's cash flows are in a tight spot. If accounts payables decrease, it means that the firm has to pay off its creditors or suppliers more quickly than before.

Poor corporate governance

Some companies are known to have questionable corporate governance practices. Firms with high promoter holdings are especially prone to unethical behaviour. Many of these are repeat offenders. Both Bhushan Steel and Prakash Industries have had corporate governance issues in the past. Prakash Industries allegedly forged documents to get coal mines allocated and diverted nearly 50% of coal into the black market. Similarly, Bhushan Steel's coal blocks in Patrapara, Orissa, were de-allocated in 2012, following investigations into the coal block allocations. Despite these instances, their stocks continued to soar.

Whenever there are allegations against a company, it should serve as a warning sign for investors to exit. The quality of management should be one of the key criteria when picking stocks. Of course, in most cases, there is no way for investors to get even a whiff of any wrongdoing. By the time the news breaks, the damage is already done. Satyam Computers is a case in point. The stock fell 78% in a single day on 7 January 2009, after chairman Ramalinga Raju admitted that the company's accounts were fudged. Investors lost more than `10,000 crore that day.

Glance through the auditor's report for any remarks that point to objectionable practices. Raised doubts about the company's survival and objected to the accounting practices used by the carrier way back in 2011.However, the management had overruled the auditors' objections. This should have sounded the alarm for investors, as the stock has been on a steady downhill spiral. While you cannot completely eliminate the risk of losses from such stocks, you can take precautions by investing only in companies with a sound management and a good track record of governance.

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