Why is it important to understand your investments?

“Caveat Emptor” or “Buyers Beware” is the central theme that runs across the world of investing. 
Every investor should have truckloads of knowledge about the investing world and where they are investing in.
In this Monetary world, people want quick money.. easy money.. fast money.. And for this, they often resort to fraudulent activities, embezzlement, treachery, etc.

Such unfair practices lead to massive scams like Satyam Scandal, that of the Lehman Brothers, Enron scandal, inventory scam of the McKesson & Robbins. These scams reflect that there are loopholes in the regulations and rules of the disclosure set by the companies act.
Situations like these make it important for investors to be very careful and act with due diligence while investing in a company.

It is crucial to clearly be able to sense whether the company is involved in fair business practices or not and whether the disclosures made by them are valid. Let us learn the four ratios of the company which might help investors identify frauds in a company:

1)    Profit margin ratios

 Profit margin ratios are a measure of the profitability of a company. It measures the revenue which is made out of the total sales of the company. Indirectly, this ratio also measures the efficiency of the company in managing its expenses. 

If the firm encounters situations such as an increase in competitors in the market or an increase in the costs of production of goods, these might lead to a decrease in the profit margins of the company.

Therefore in order to keep the margins consistent:

• The company might reduce its expenses.

• Overstate its income (profit margin ratio will shoot up)

• Overstate expenses (profit margin ratio will decline)

2)    Inventory days and receivable days

Inventory days and receivable days are a part of the cash conversion cycle of a company. 

The collection ratio should be consistent.  Usually, a higher collection ratio is preferred because it shows that the receivables are collected fast.

An increase in the days that inventory stays in stock leads to additional expenses which can be in the form of storage costs, risk of inventory, etc.

Inconsistency or significant variance in this ratio is a red flag for fraudulent investigators. This ratio is affected by the selling and purchase of inventory as well as by understatement of costs of the goods sold.

3)    CFO/PAT

Cash flow from operating ratios calculates how well a company is able to cover its current liabilities from these cash flows which are generated from the daily operating activities of the firm. It helps to identify the liquidity position of the company.

Cash flow is a very important statement for any company because:

•  its credit rating is allotted on the basis of the CF, especially the cash flow from operations. 

• Therefore to show a stronger cash flow of the firm, the management might manipulate it by adding the receipts from investments in short term securities which are a part of short term investments.

•  They can also distort the information by not deducting the cash which has already been paid for the accounts payable from the cash in hand or by inflating the cash inflow by accelerating the funds coming in through receivables i.e. by reducing the number of receivable days.

4)    Total asset turnover ratio

This is a kind of efficiency ratio that measures the ability of the generated sales from its assets. That is, it interprets how well a company is able to make revenue in terms of its sales in relation to its assets.

In order to display the efficient working of the assets to generate revenue:

•  the management of the firm might even try to decrease the assets unnecessarily. (a higher ratio represents better efficiency and lower ratios show that the assets are not efficient enough to generate the revenue)

• The value of total assets could be reduced by charging excessive depreciation on the fixed assets, more than the current rate of depreciation. 

• Or by reducing the value of inventory by maintaining less of stock or by increasing reducing the inventory days.

Conclusion

Not only People, but your investments will also play with your emotions if you don’t understand your investments and simply just invest it. 
These above ratios will leave you in a vacuum. There is more to understand and calculate before making any investment. 

Read how 5 components of P&L influence Investor's Decisions