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How to identify a Satyam

The modified C-score helps identify companies which may be cooking their books

How to identify a Satyam

The C-Score was originally developed by James Montier to look at companies that resorted to cooking their books. Montier remarked, 'In good times, few focus on such 'mundane' issues as earnings quality and footnotes. However, this lack of attention to 'detail' tends to come back and bite investors in the arse during bad times.'

Montier also found the C-Score an effective way to identify short-selling candidates. Stocks with a C-Score of five and a price-to-sales ratio of greater than two generated around negative 4 per cent absolute return every year. Think of the C-Score as a way to identify what companies to run far, very far, from.

Here is how Montier developed the C-Score:

  1. Is there a growing divergence between net income and operating cash flow? This means earnings can be pumped up; cash is harder to do.
  2. Are days sales outstanding (DSO) increasing? Are companies flushing stocks down to dealers?
  3. Are days sales of inventory (DSI) increasing? Are stocks flying off the shelves or catching dust?
  4. Are other current assets increasing vs revenues? This is a cross-check for DSO and DSI.
  5. Are there declines in depreciation relative to gross property, plant and equipment? Companies tend to play with depreciation rules to pump up profits.
  6. Is total asset growth high? High asset growth has been seen to lower performance.
    To the above Montier's checks, we added three of our own.
  7. Are debtors as per cent to revenue increasing? This indicates if credit sales are being made to boost the top line.
  8. Is assets quality improving or declining? Asset quality is the ratio of non-current assets other than plant, property and equipment to total assets. Think of it as non-productive assets.
  9. Is accrual ratio high or low? Total accruals are calculated as the change in working capital accounts other than cash-less depreciation. The accrual ratio gives the difference between accrual accounting and cash actually made out of it. A high ratio means that there is a high difference between the cash realised and the earnings reported.

Companies get a point for qualifying: one for yes and a zero for no. A higher C-Score is a higher probability of manipulation.

How do the BSE 500 companies score on this test? Eliminating for financials, 38 per cent of the remaining companies get knocked off for a score of three or more (the higher the score, the more risk of manipulation). Also of interest is that only 14 per cent of the stocks have a modified C-Score of zero (the best). The two sectors that top the list of the lowest C-Score include technology and pharma. At the opposite end of the spectrum, 19 per cent of the companies reported a C-Score of four or more.

Do keep in mind that the C-Score can be the starting point of investigating which stock to buy or avoid. When making that decision, ask why a company scores as it does on an individual parameter and never use a single parameter to come to a decision.