"Satyam is Sanskrit for Enron"

Prof Bob Paretta is back again with another lesson on reading financial statements. He shows that it's possible to spot corporate fraud using publicly available records before the market finds it or the company implodes. Remember Satyam? That Indian outsourcing company found with massive accounting fraud only 2 months ago? (See NYTimes article.) Here's Bob's Excel spreadsheet analysis of the cash flows and income statements that Satyam posted over the past 5 (count 'em, 5) years. (you'll need MS Excel to open it.) Paretta's Cash flow analysis for Satyam.

The gospel according to Paretta: "The spreadsheet shows an important accounting indicator -- the QofE (quality-of-earnings) ratio. It's the ratio of cash flow from operations to net income. Because net income includes non-cash expenses, cash flow from opns (CFO) should typically be higher than net income because to arrive at CFO you add back large expenses like depreciation and accrued expenses or expenses you did not pay for yet (Accts payable) and subtract smaller revenues that did not produce cash, like increases in Accts receivables. When CFO/NI is not greater than 1, it brings into question whether net income includes revenues that are being recorded before the're actually earned. (or even fictitious revenues!) So when QofE is less than one for even one period, it's a red flag and when it remains so over nearly a 5 year period, as in the case of Satyam, it is a big red flag! If you fictictiously inflate revenue then you also have to inflate accounts receivable; otherwise the accounts don't balance. Satyam's receivables rose steadily over the five year period and also as a percentage of net income. That relationship can jump around for a period or two (also a red flag) but when it grows steadily then you have to ask, why are they increasingly not collecting the revenues they are recording in A/R (big red flag). If you're a Satyam kind of company, if you want CFO to rise so that it exceeds or approaches net income you have to either stop paying your A/P or you have to make up fictitious A/P, because A/P reduces net income but does not affect CFO. Notice how on the second page of the spreadsheet A/R and A/P and related accruals are increasing and are an increasing percentage of net income? Again if it happens just one period, it is a blip on the radar...a pink flag. If it keeps happening, it is another big red flag. It means you are increasingly not collecting your A/R and you are not paying your debts. The conclusion is you are either a crook or you don't know how to run your business. So three big red flags and it is time to sell, call the cash flow police, or both. The mystifying thing is that Raju admits that 94%, or $1 billion, of the company's cash balance was fictitious. That should have been caught by the auditors (PwC) unless the banking system in India is so corrupt that banks sent PwC false confirmations. In any case Raju could not have done this alone. There had to be collusion on a massive scale to the extent we have never seen before. The international fallout from this is going to be huge. Stay tuned."
Yes we Can! (stay tuned, that is.)
Thanks again, Doctor Bob.