Satyam Systems, a global IT company based in India, has just been added to a notorious list of companies involved in fraudulent financial activities, one that includes such names as Enron, WorldCom, Societe General, Parmalat, Ahold, Allied Irish, Bearings and Kidder Peabody. Satyam's CEO, Ramalingam Raju, took responsibility for broad accounting improprieties that overstated the company's revenues and profits and reported a cash holding of approximately $1.04 billion that simply did not exist.
This leads one to ask a simple question: How does this keep happening?
Saturday, January 17, 2009
Behind the Satyam scandal
India vowed to strengthen laws to prevent corporate fraud after Satyam Computer, the country’s fourth-largest software company, shocked investors by revealing profits had been falsely inflated for years.Chairman Ramalinga Raju resigned on Wednesday after revealing India’s biggest corporate scandal in memory, sending the company’s shares plunging nearly 80%.The following is an overview of how the fraud escaped detection for so long and what compelled a soft-spoken man born into a family of farmers to risk all.Q: How did Satyam escape detection?A: On the face of it, New York-listed Satyam did everything by the rulebook, with an international firm auditing its books, declaration of accounts in accordance with Indian and U.S. standards, and the requisite number of independent directors with excellent credentials, including a Harvard business school professor and a former federal cabinet secretary.Mr. Raju, in his now famous 5-page letter outlining the deception, said no other board member—past or present—was aware of the financial irregularities.Regulators were blindsided, and analysts and experts say there are “systemic flaws” in accounting and audit practices.About $1 billion, or 94% of the cash, on the company’s books was fictitious, Mr. Raju said. Manipulation of the cash flow may be a reason why the fraud was undetected.“Companies have manipulated P&L (profit and loss) accounts before, but cash flow is the Holy Grail—you don’t tamper with it,” said Saurabh Mukherjea, an analyst at UK-based research firm Noble Group.“Auditors generally assume if there is cash, things are OK. But there are plenty of accounting and governance loopholes.”India also lacks a culture of dissent, with shareholders and independent directors reluctant to question company founders.Q: What was the motive?A: India’s $50-billion information technology industry—the poster child for India’s economic liberalization and rapid growth—expanded at a scorching pace on the back of outsourcing demand from Western firms.At the height of the boom, top software firms Tata Consultancy Services, Infosys Technologies, Wipro and Satyam consistently reported annual 50% increases in profits every quarter.Pressure to maintain this pace of growth, please investors and shareholders and justify inflated P/E multiples during a six-year bull run on the stock market have all been cited as reasons why Satyam cooked the books.Some news reports say Mr. Raju was an aggressive investor in failed dotcoms, and the family also put money in real estate.Mr. Raju, in his letter, said he had “not benefited in financial terms” as a result of the inflated accounts.Q: Are there other Satyams out there?A: Most certainly, say analysts and industry experts.While there has been a plea from chief executives across the board against painting all of corporate India with the same brush, Noble Group estimates at least a fifth of the top 500 listed companies practice “creative accounting.”“At its most innocent it is not illegal, but account manipulation is very pervasive,” said Mr. Mukherjea.Q: What needs to be done to prevent another Satyam?A: Tighter rules for accounting and corporate governance, including appointment of independent directors by selection committees, and greater oversight from regulatory and government authorities.Noble Group also suggests separation of audit and consultancy functions at companies—as is the case in the U.S.—and quicker publication of annual reports.
Satyam Scandal is a Huge Blow to Indian Tech
The terror attacks on Mumbai were just a tremor for the country’s tech industry compared to the shocks coming from the Satyam scandal. Earlier today, Ramalinga Raju, Satyam’s founder and longtime chairman, admitted in a letter to the board that he had been cooking the books for years to make up for revenue and profit shortfalls. Read the details in this report by my BW colleague, Manjeet Kripalani. In his letter, Raju wrote that the cover-up finally got the best of him: “It was like riding a tiger, not knowing how to get off without being eaten.”
This admission will have a crippling impact on Satyam. Its chances of getting new business are nil. Don’t expect its current customers to abandon the company overnight. That’s not easy in a tech services business where the operations of the client and service provider are so interwoven. On the other hand, it’s possible that the company may collapse financially, in which case clients will have no choice but to flee.
Which brings us to a bigger shock: This betrayal of trust could have a major impact on the entire Indian tech services industry. The industry has spent 20 years building up credibility with Western clients, but this disaster will make many US and European clients rethink their reliance on Indian outsourcing. Don’t expect offshore outsourcing to fall off a cliff, but there will be serious repercussions.
There’s another impact that most people won’t be aware of. Raju, through his Byrraju Foundation, has been a leader in bringing economic development to farm communities in his home state of Andhra Pradesh, and also in providing emergency medical services to people of the state state. Will all of this collapse now?
This guy seemed to be a model citizen. But all that is gone now. It’s a tragedy not just for him and the employees of Satyam, but for the entire country.
This admission will have a crippling impact on Satyam. Its chances of getting new business are nil. Don’t expect its current customers to abandon the company overnight. That’s not easy in a tech services business where the operations of the client and service provider are so interwoven. On the other hand, it’s possible that the company may collapse financially, in which case clients will have no choice but to flee.
Which brings us to a bigger shock: This betrayal of trust could have a major impact on the entire Indian tech services industry. The industry has spent 20 years building up credibility with Western clients, but this disaster will make many US and European clients rethink their reliance on Indian outsourcing. Don’t expect offshore outsourcing to fall off a cliff, but there will be serious repercussions.
There’s another impact that most people won’t be aware of. Raju, through his Byrraju Foundation, has been a leader in bringing economic development to farm communities in his home state of Andhra Pradesh, and also in providing emergency medical services to people of the state state. Will all of this collapse now?
This guy seemed to be a model citizen. But all that is gone now. It’s a tragedy not just for him and the employees of Satyam, but for the entire country.
The story behind numbers
Talking about numbers reminds us of the mathematics classes in school days, when we would invariably get lost in a maze of numbers?mensurations, formulae, graphs et al. Numbers still remain a put-off. And yet, we seem to share a love-hate relationship with them; otherwise, why do we use them so much and so often?
Through the following story, we will try and demystify some of the most important numbers used in the world of business. The story would come in several episodes. You would find an interesting tale behind each number, only if you care to listen. Our objective is to help you evaluate businesses for investment purposes by making numbers easy to comprehend. After all, ?Owning equity is akin to owning a company?. And it is imperative that you understand the numbers of the company that you invest in, no?
A business can actually be assessed on the basis of several parameters?profitability (whether it is making money), efficiency (if it?s making the best possible use of its resources), leverage (whether it has the right mix of debt and equity), solvency (whether it can pay off its debts), liquidity (whether it has cash to meet its day-to-day needs) and so on. All these point to the overall health of a company?and hence, to the health of its shareholders.
In order to interpret the company on these parameters, we need to know what goes behind the numbers in the balance sheet and the profit & loss statement.
Let us talk about a company that seeks to manufacture soaps. To begin with, it will need a plant in place. Without the plant there would be no operations, right? To know what the company has, the best place to look for is its balance sheet.
Balance sheetA Balance sheet is like a snapshot that captures a mood at a particular instant. It is a financial snapshot of a company at a given point of time.
Gross fixed assets: Coming to our example, to make soap, the company needs a plant. It also requires some land along with other infrastructure to set up an office. Other facilities like pipelines and waste disposal systems are also essential. These together constitute the gross fixed assets of the company.
Accumulated depreciation: But nothing lasts forever, the assets wear and tear and need to be replaced at a future date. So, every year, an amount is set aside to meet these expenses. This amount is known as depreciation charges for the year. And the cumulative amount collected for the given period shows up in the balance sheet as accumulated depreciation.
Net fixed assets: These are nothing but the gross fixed assets less the accumulated depreciation. All they connote is the book cost of the existing assets.
Capital work in progress: When the company grows and expands its operations, there are often unfinished plants, buildings under construction and so on. These are clubbed under capital work-in-progress.
Meanwhile, the plant is ready to commence operations. But can we straightaway get into the act of manufacturing soaps? Not really. Some other current requirements, those of raw materials, need to be met first. The suppliers of raw materials also need to be paid.
Current assets, current liabilities: Liabilities like the creditors (suppliers of raw materials, fuel, etc. on credit) and provisions for tax that need to be paid immediately are called current liabilities. Similarly, there are some current assets. Unlike plants or buildings some assets like debtors and inventory of soaps that are in the company?s godown can be converted into cash more easily. What is crucial here is that the company?s current assets and liabilities balance comfortably; so that it does not face a cash crunch or has surplus of cash. The difference between the current assets and current liabilities is called net current assets.
But all this can happen provided there are funds. So, the company raises funds?
Equity: This is the amount contributed by the shareholders of the company at the initiation of the business. This is simply the number of shares multiplied by the face value.
Reserves and surplus: As we saw in the profit and loss statement, from the total proceeds received, all the expenses have to be taken care of, tax has to be paid, and dividend has to be given to shareholders. The balance is called the retained profit. This is what the company would retain to re-invest in the business to propel further growth. This would get reflected in its balance sheet as reserves and surplus.
Equity and reserves are together known as shareholders? funds?funds at the command of shareholders to be invested in the business. They are also referred to as net worth.
Loans: But the entire business can rarely be funded by shareholders? funds alone. A company usually resorts to debt to bridge the gap between the requirement and the supply. These are called loan funds. Thus, we have the liabilities?funds owed to shareholders and debt holders?these constitute the company?s debts.
Investments: After the operations start, money begins to flow in. Just like you put your surplus cash in stocks and other investment avenues, so does the company and the amount is shown as an asset (hopefully, the company makes sound investment decisions!).
The statement that takes stock of the operations of the company during the entire given period is called the profit and loss statement.
Profit and loss statementWe are very familiar with the figure called net profit. So, what is the story behind this number? We have to cross several hurdles before we can actually understand what net profit means (remember, it is also called bottom line!). Let us take a fast local and halt at important stations that would help us understand net profit better.
Operating profit: It is one of the prime drivers of profitability at the end of the day. If the company produces 10 soaps at a cost of Rs2, spends Rs0.50 on advertising them and pays a commission of Re1 on each soap to the retailer/dealer, then its total production cost works out to Rs35. It then sells each soap for Rs10, earning a total of Rs100, which is its net realization. But, its operating profit works out to only Rs65 (net realisation minus total production cost). Thus, operating profit is a good indicator of a company?s ability to make money from its core operations.
Depreciation: For its operations, the company uses capital?like plant and machinery. Depreciation is a cost that is charged for use of plants and building. It is not cash expenditure. Any asset?be it a plant or a machinery?eventually wears off and needs to be replaced. Depreciation is an amount set aside every year towards replacement of the assets.
Finance charges: The company requires funds to invest in assets and to run its day-to-day operations. After all, a plant has to be put in place and costs incurred in producing and selling the products, before the company can reach the final consumer?and more importantly, before money can be realized! These expenses are funded by a mix of shareholders? funds (called equity) and borrowings from others (debt). Sometimes, the company might also lease a plant from a different party for a periodic payment (just like you might rent a flat). While the company is not obliged to pay its shareholders (after all, it is their company and hence, its risks and rewards are also their own!), it has to pay for using others? funds. Thus, the company has finance charges like interest and lease rentals.
Other income: While operating income can be viewed as salary, other income can be compared to bonus. The company invests its surplus cash in several avenues like debentures and equity of other companies. These investments yield dividends and interest income, which together constitute other income.
Adjustments for extraordinary items: Sometimes, there are one-time expenses in the form of provisions (for tax, dividends, bad debts, etc.), write-offs (treating some bad loans as permanent losses), etc. Then, there may also be a one-time income from sale of certain assets. All these classify as extraordinary items. While analysing performance, one should discount these items to get a better picture of a company?s business operations.
PBT: After paying for all the expenses, this is what is left in the company?s kitty.
Tax: But then, do you carry your entire salary home? Neither does the company. Based on tax regulations it has to shell out Income Tax ? its contribution to the state kitty.
Net profit: Well, home at last! This is one number that summarises the company?s operations.
Dividends: After paying all the other stakeholders in the business, the company pays dividends to its shareholders. But, how often have you bought a stock for dividend purposes only? If fixed payment is what one is looking for, then there are debt instruments after all! So, how else do the shareholders benefit? They gain from capital appreciation, which is linked to the fortunes of the company.
Thus, we see that a company?s net profit is dependent on several factors and prudent management of each would adds to its growth.
Moral of the story:
§ A company invests money in assets to commence operations that are financed through debt and equity.
§ Balance sheet gives a snapshot view of a company?s financial health at a particular point of time.
§ The profit and loss statement summarizes a company?s operations.
Through the following story, we will try and demystify some of the most important numbers used in the world of business. The story would come in several episodes. You would find an interesting tale behind each number, only if you care to listen. Our objective is to help you evaluate businesses for investment purposes by making numbers easy to comprehend. After all, ?Owning equity is akin to owning a company?. And it is imperative that you understand the numbers of the company that you invest in, no?
A business can actually be assessed on the basis of several parameters?profitability (whether it is making money), efficiency (if it?s making the best possible use of its resources), leverage (whether it has the right mix of debt and equity), solvency (whether it can pay off its debts), liquidity (whether it has cash to meet its day-to-day needs) and so on. All these point to the overall health of a company?and hence, to the health of its shareholders.
In order to interpret the company on these parameters, we need to know what goes behind the numbers in the balance sheet and the profit & loss statement.
Let us talk about a company that seeks to manufacture soaps. To begin with, it will need a plant in place. Without the plant there would be no operations, right? To know what the company has, the best place to look for is its balance sheet.
Balance sheetA Balance sheet is like a snapshot that captures a mood at a particular instant. It is a financial snapshot of a company at a given point of time.
Gross fixed assets: Coming to our example, to make soap, the company needs a plant. It also requires some land along with other infrastructure to set up an office. Other facilities like pipelines and waste disposal systems are also essential. These together constitute the gross fixed assets of the company.
Accumulated depreciation: But nothing lasts forever, the assets wear and tear and need to be replaced at a future date. So, every year, an amount is set aside to meet these expenses. This amount is known as depreciation charges for the year. And the cumulative amount collected for the given period shows up in the balance sheet as accumulated depreciation.
Net fixed assets: These are nothing but the gross fixed assets less the accumulated depreciation. All they connote is the book cost of the existing assets.
Capital work in progress: When the company grows and expands its operations, there are often unfinished plants, buildings under construction and so on. These are clubbed under capital work-in-progress.
Meanwhile, the plant is ready to commence operations. But can we straightaway get into the act of manufacturing soaps? Not really. Some other current requirements, those of raw materials, need to be met first. The suppliers of raw materials also need to be paid.
Current assets, current liabilities: Liabilities like the creditors (suppliers of raw materials, fuel, etc. on credit) and provisions for tax that need to be paid immediately are called current liabilities. Similarly, there are some current assets. Unlike plants or buildings some assets like debtors and inventory of soaps that are in the company?s godown can be converted into cash more easily. What is crucial here is that the company?s current assets and liabilities balance comfortably; so that it does not face a cash crunch or has surplus of cash. The difference between the current assets and current liabilities is called net current assets.
But all this can happen provided there are funds. So, the company raises funds?
Equity: This is the amount contributed by the shareholders of the company at the initiation of the business. This is simply the number of shares multiplied by the face value.
Reserves and surplus: As we saw in the profit and loss statement, from the total proceeds received, all the expenses have to be taken care of, tax has to be paid, and dividend has to be given to shareholders. The balance is called the retained profit. This is what the company would retain to re-invest in the business to propel further growth. This would get reflected in its balance sheet as reserves and surplus.
Equity and reserves are together known as shareholders? funds?funds at the command of shareholders to be invested in the business. They are also referred to as net worth.
Loans: But the entire business can rarely be funded by shareholders? funds alone. A company usually resorts to debt to bridge the gap between the requirement and the supply. These are called loan funds. Thus, we have the liabilities?funds owed to shareholders and debt holders?these constitute the company?s debts.
Investments: After the operations start, money begins to flow in. Just like you put your surplus cash in stocks and other investment avenues, so does the company and the amount is shown as an asset (hopefully, the company makes sound investment decisions!).
The statement that takes stock of the operations of the company during the entire given period is called the profit and loss statement.
Profit and loss statementWe are very familiar with the figure called net profit. So, what is the story behind this number? We have to cross several hurdles before we can actually understand what net profit means (remember, it is also called bottom line!). Let us take a fast local and halt at important stations that would help us understand net profit better.
Operating profit: It is one of the prime drivers of profitability at the end of the day. If the company produces 10 soaps at a cost of Rs2, spends Rs0.50 on advertising them and pays a commission of Re1 on each soap to the retailer/dealer, then its total production cost works out to Rs35. It then sells each soap for Rs10, earning a total of Rs100, which is its net realization. But, its operating profit works out to only Rs65 (net realisation minus total production cost). Thus, operating profit is a good indicator of a company?s ability to make money from its core operations.
Depreciation: For its operations, the company uses capital?like plant and machinery. Depreciation is a cost that is charged for use of plants and building. It is not cash expenditure. Any asset?be it a plant or a machinery?eventually wears off and needs to be replaced. Depreciation is an amount set aside every year towards replacement of the assets.
Finance charges: The company requires funds to invest in assets and to run its day-to-day operations. After all, a plant has to be put in place and costs incurred in producing and selling the products, before the company can reach the final consumer?and more importantly, before money can be realized! These expenses are funded by a mix of shareholders? funds (called equity) and borrowings from others (debt). Sometimes, the company might also lease a plant from a different party for a periodic payment (just like you might rent a flat). While the company is not obliged to pay its shareholders (after all, it is their company and hence, its risks and rewards are also their own!), it has to pay for using others? funds. Thus, the company has finance charges like interest and lease rentals.
Other income: While operating income can be viewed as salary, other income can be compared to bonus. The company invests its surplus cash in several avenues like debentures and equity of other companies. These investments yield dividends and interest income, which together constitute other income.
Adjustments for extraordinary items: Sometimes, there are one-time expenses in the form of provisions (for tax, dividends, bad debts, etc.), write-offs (treating some bad loans as permanent losses), etc. Then, there may also be a one-time income from sale of certain assets. All these classify as extraordinary items. While analysing performance, one should discount these items to get a better picture of a company?s business operations.
PBT: After paying for all the expenses, this is what is left in the company?s kitty.
Tax: But then, do you carry your entire salary home? Neither does the company. Based on tax regulations it has to shell out Income Tax ? its contribution to the state kitty.
Net profit: Well, home at last! This is one number that summarises the company?s operations.
Dividends: After paying all the other stakeholders in the business, the company pays dividends to its shareholders. But, how often have you bought a stock for dividend purposes only? If fixed payment is what one is looking for, then there are debt instruments after all! So, how else do the shareholders benefit? They gain from capital appreciation, which is linked to the fortunes of the company.
Thus, we see that a company?s net profit is dependent on several factors and prudent management of each would adds to its growth.
Moral of the story:
§ A company invests money in assets to commence operations that are financed through debt and equity.
§ Balance sheet gives a snapshot view of a company?s financial health at a particular point of time.
§ The profit and loss statement summarizes a company?s operations.
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