Corporate misgovernance: Look for these slippages

"An investment in knowledge pays the best interest," said statesman Benjamin Franklin. This statement a few centuries old still holds sway today when investing your hard-earned money on the fickle equity markets.

With just some knowledge, research and information, one can try to insulate one's earnings from the deliberate wrongdoings on India's bourses.

"A company may have the best corporate governance policies, but slippages (in corporate governance) they face is in terms of effective and robust execution of the same and that is where the drag begins," says Tanvi Kanchan, Head – Corporate Strategy, Anand Rathi Shares and Stock Brokers, about how (good) corporate governance in companies starts disintegrating.

Fortunately, experts give us an insight into how the investor can recognise the company that he or she has invested in is on the road of corporate misgovernance.

"Related party transactions and loans to subsidiaries are a sign that promoters are running financial mismanagement in that particular company," says Pritam Deuskar, fund manager, Bonanza Portfolio, who indicated about how an investor can realise that the company that they have invested in is having bad corporate governance by the management.

Making payments from the financial reserves of the company, as well as sudden losses are other signs of fiduciary mismanagement by the existing management of a company.

"A sign of corporate misgovernance is that pledged shareholding is increased without any corresponding increase in the company's business," says Kishor Ostwal, MD, CNI Research. Promoters can pledge the majority of their shares if they want to divert into other businesses.

Kingfisher Airlines where the promoters had pledged 100% of the shareholding is a case in point.

"Except for MNCs (multinational companies), there seems a fixation among domestic promoters to play in their own shares," says an analyst. In most such cases promoters and operators are hand in glove and try to manage the stock with very high volumes. There is a perception that high volumes in the stock are good and an investor could get an easy exit and this perception draws the line of control.

"All the companies that have busted the mismanagement, siphoning of funds, lack of corporate governance have one thing in common, i.e. is very high volumes at a particular point in time which attracts domestic as well as global investors," says the analyst.

The mismanagement of cash flows expose these promoters to high risk in the stock market and eventually find themselves in a situation where things go out of control. Companies with such mismanagements include Jet Airways, Vakrangee, and Manpasand Beverages.

"An investor needs to look at the company's growth- how aggressively the company has been expanding and if the same is substantiated by the inputs," says Kanchan.

Additional clues about corporate misgovernance include transparency of the company in disclosure documents, the stability of the management team – the tenor and the track record of key personnel of the company, liquidity and cash-flow management.

"An investor needs to look at undue benefits to the board of directors and the imposition of the will by the retired founders of the company," notes Devang Mehta, Head - Equity Advisory, Centrum Wealth Management about signs of misgovernance in listed companies.

"Bad corporate governance starts with mismanagement of cash flows," explains Ostwal. "When the cash flow goes astray, promoters resort to tricks like pledging of shares to raise funds (Kingfisher), fudging the accounts to please the bankers and big investors (Satyam, ILFS and CG Power), dilute stake to raise funds, try to divert in unrelated businesses (Suzlon), join hands with market operators and manage their own stock," says Ostwal.

"While the selling of shares (by the promoters) is not per se a problem, repeated and consistent selling of shares year after year (by the promoter group) is a sign that something is wrong with the company," notes Deuskar.

Also, the non-payment of taxes and dividends are examples of corporate misgovernance. "Any company that is actually profitable will not hesitate to pay their taxes and dividends," affirms Deuskar.

A very high pledged shareholding (by the promoter group) is a no-no as such shares can be sold by the pledged authorities thus creating negative fluctuation in the share prices.

Even within the heartbeat of the company, the P and L (profit and loss) statement, some clues indicates mismanagement in a company.

By looking at these numbers (P and L, cash flow, balance sheet, etc), an investor can assess how much debt does the company has in comparison to the equity, whether in short-term the cash is declining or accelerating, the tangible assets, where the profits are being spent, whether the funds allocated to research are yielding good results. "These numbers reveal mismanagement of funds or any negligence at the management level," says Kanchan.

"Negative cash flows suggest that the promoter is unable to manage the business well unless it's for investment in production facilities," informs Ostwal. In that case one has to assess when could the company turn cash surplus.

Besides cash flows, one has to analyse labour costs, interest costs, manufacturing overheads, power costs in relation to sales for the last three years to judge efficiency levels. If the company is doing well consistently at the operating level then investors can breathe easy.

Also important is working capital requirements. If a company gets and manages working capital effectively then all is well. But, if the working capital is diverted towards long-term capital (most of the cases) then the mismatch arises, which indicates that promoters could be trying to manipulate the accounts.