NJ Mutual Fund’s Forensic & Governance Model is designed to detect red flags through quantitative measures. The model identifies companies prone to:

• Earnings Manipulation: Detecting aggressive revenue recognition practices.
• Hidden Liabilities: Uncovering off-balance-sheet debts.
• Governance Risks: Assessing factors like promoter integrity and independence of auditors.

The following are a few of the parameters used to evaluate the stocks:

1) Promoter Pledge: This measures the percentage of promoters’ shares pledged as collateral.

Company A, with a 5% promoter pledge, is considered to have lower governance risk compared to Company B, which has a 40% pledge. A higher pledge ratio in Company B may signal that the promoters are financially stretched, which could lead to potential conflicts of interest or liquidity concerns. High pledging may also lead to forced share sales, impacting stock price stability. This makes Company A relatively less risky in terms of the promoters’ integrity and alignment of interests with minority shareholders.

Source: CMIE, NJ’s Smart Beta Platform. Data from September 30, 2009, to December 31, 2024. The High Promoter Pledge portfolio consists of companies that rank in the bottom Decile (Bottom 10%) based on the promoter pledge parameter. Probability of Loss (%) is calculated by dividing the number of negative observations by total number of observations. Past performance may or may not be sustained in the future and is not an indication of future returns.

2) Operating Cash Flow to EBITDA: This ratio compares the actual cash generated from operations to earnings before interest, taxes, depreciation, and amortization. A significant discrepancy may suggest earnings manipulation such as aggressive revenue recognition by inflating receivables, channel stuffing and over-invoicing, and inventory manipulation. As a thumb rule, a ratio between 80% to 200% of EBITDA is generally considered as healthy.

Company X, with an 80% operating cash flow to EBITDA ratio, demonstrates robust cash generation that aligns with its earnings, signalling a high quality of reported earnings and healthy accounting practices. In contrast, Company Y, with only a 20% ratio, shows a significant discrepancy between cash flow and earnings, which may be a sign of aggressive accounting or earnings manipulation. This makes Company X a more reliable choice from a forensic viewpoint.

Source: CMIE, NJ’s Smart Beta Platform. Data from September 30, 2006, to December 31, 2024. The Low OCF to EBITDA Portfolio consists of companies falling in the bottom decile based on their OCF to EBITDA values. Only Non Financial companies are considered. Companies with negative EBITDA are not considered. Probability of Loss (%) is calculated by dividing the number of negative observations by total number of observations. Past performance may or may not be sustained in the future and is not an indication of future returns.

3) Contingent Liabilities to Net Worth: This parameter assesses potential obligations, often camouflaged in the notes outside a company’s balance sheet, that could impact a company’s financial stability and solvency. A high ratio indicates that contingent liabilities if recognised as actual and measurable liabilities, pose significant risks to a company’s future net worth.

Company M, with a 5% contingent liabilities to net worth ratio, is in a stronger financial position, as its contingent liabilities are relatively low compared to its net worth. In contrast, Company N, with a 25% ratio, faces higher financial uncertainty, as its contingent liabilities could potentially affect its financial stability and earnings in the future. Even in the worst-case scenario, if all of Company M’s and Company N’s contingent liabilities are later recognised as liabilities, then Company M’s net worth would decrease by just 5% whereas Company N’s resultant net worth would be equal to only 75% of its original net worth. This makes Company M a more safe investment when considering potential balance sheet risk.

Source: CMIE, NJ’s Smart Beta Platform. Data is from September 30, 2006 to December 31, 2024. The High Contingent Liability to Net Worth Portfolio consists of companies in the top decile with the highest Contingent Liability to Net Worth parameter values in the Nifty 500 universe. Companies with negative Net Worth and Lending companies are not considered. Probability of Loss (%) is calculated by dividing the number of negative observations by total number of observations. Past performance may or may not be sustained in the future and is not an indication of future returns.

4) Auditor Remuneration Growth: A significant increase in auditor fees may indicate potential conflicts of interest, a lack of independence, or the need for more extensive auditing due to concerns about the company’s financial health. If auditor fees rise disproportionately compared to revenue or profit growth, it could suggest undisclosed financial risks, increased scrutiny, or potential financial misreporting.

For example, Company’s reported a 15% increase in revenue but a 70% surge in auditor fees, raising questions about possible financial irregularities requiring deeper scrutiny. Instead of looking at absolute changes, comparing the auditor remuneration growth relative to sales or earnings growth provides a better indication of compromise in the auditor’s independence.

Source: CMIE, NJ’s Smart Beta Platform. Data is from September 30, 2006 to December 31, 2024. The High Auditor Remuneration Growth Portfolio consists of the companies from the Nifty 500 universe with the highest growth in auditors’ remuneration parameter values. Probability of Loss (%) is calculated by dividing the number of negative observations by total number of observations. Past performance may or may not be sustained in the future and is not an indication of future returns.

Other Parameters

• Capital Work in Progress (CWIP) to Net Fixed Assets (NFA): A high CWIP to NFA ratio may indicate stalled projects or inefficient asset utilization, which can be a red flag for investors. While a moderate level of CWIP is expected in growing companies, a consistently high CWIP over multiple years could signal governance lapses, where assets are kept under development to defer depreciation and inflate profits. A temporary spike in CWIP may be justified in the early stages of expansion, but if the ratio remains elevated over an extended period, it raises concerns about cost overruns, mismanagement, or financial manipulation.
  For example, Company P, with a five-year median CWIP to NFA of 10%, reflects efficient capital deployment and a well-managed expansion strategy. In contrast, Company Q, with a consistently high five-year median ratio of 50%, suggests prolonged asset construction, increasing the risk of inefficiencies and potential governance concerns.
• Goodwill & Impairment: Sudden impairments in goodwill can indicate that previous acquisitions were overvalued or that the company is struggling with post-acquisition integration. While one-time impairments may be due to changing business conditions, frequent or substantial goodwill write-offs relative to the total intangible assets can reflect deeper issues, such as flawed valuation methods, poor acquisition strategies, aggressive accounting practices, or financial mismanagement.
  For instance, Company R had goodwill making up a significant portion of its total intangible assets, but within two years of acquiring a subsidiary, it impaired goodwill equivalent to 40% of its total intangible assets. Such a high goodwill impairment ratio relative to intangible assets raises concerns about management’s due diligence in M&A decisions and the potential misrepresentation of financial health and a bloated balance sheet in prior years.
• Inconsistent Tax Recognition: A company’s tax management approach reflects its financial transparency and governance. Significant fluctuations in the effective tax rate may signal aggressive strategies to manipulate profits. While some variability is normal owing to deferred taxes arising due to differences in accounting treatment as per the financial reporting standards and the Income Tax laws, erratic swings can raise concerns about integrity. Additionally, the ratio of cumulative tax expense reported in the P&L to the actual tax payments reported in the cash flow statement over a medium to long period offers insight into tax consistency. A persistent mismatch between reported and actual tax payments may indicate earnings management. Companies with stable tax rates and alignment between reported and actual paid taxes often demonstrate stronger governance, while extreme volatility warrants closer scrutiny.
  For example, Company R has maintained a stable effective tax rate of around 25% over the past five years, with only slight variations due to regulatory changes. The ratio of its cumulative P&L taxes to cumulative cash flow taxes is consistent. In contrast, Company S has experienced significant fluctuations in its effective tax rate, ranging from 15% to 35% over the past five years. Additionally, its cumulative P&L taxes significantly underestimate its actual tax payments, raising concerns about aggressive accounting practices such as underestimation of taxes to artificially boost profits. This inconsistency suggests potential earnings management, warranting further scrutiny of the company’s financial integrity.
• Volatility in Depreciation Rate: Significant fluctuations in depreciation rates can distort the earnings quality of a company. Frequent changes in depreciation methods, estimates or rates without significant changes in a company’s property, plant, and equipment (PP&E) may be a sign of earnings management, where companies adjust depreciation to influence profits. A stable and consistent depreciation rate and policy are important for assessing a company’s financial health and ensuring that its reported earnings are reflective of its true performance.
  For example, Company T reduced its depreciation rate by 30% in a single year, artificially boosting profits, only to reverse the policy a year later, highlighting potential earnings manipulation.