On Dalal Street, a rising share price can hide a weak balance sheet for a long time, until it can’t. Retail investors have lost heavily by taking reported revenue and net profit at face value. Whether you are looking at a mid-cap manufacturer or a newly listed tech company on the NSE, a basic forensic check of the financial statements is worth doing yourself.
Accounting gimmicks aren’t always illegal. Often they are aggressive readings of Ind AS (Indian Accounting Standards) used to dress up the numbers before a company raises debt or issues new shares. Here are five of the most common red flags, and where to find them.
1. Profits rising, cash flow flat
This is the oldest warning sign. Under accrual accounting, a company books revenue when it raises an invoice, even if the customer hasn’t paid. If net profit is growing 30% a year but cash flow from operations (CFO) stays flat or negative year after year, the profit isn’t turning into cash.
- Where to look: compare profit after tax (PAT) in the profit and loss statement with CFO in the cash flow statement, over at least three to five years.
- The gimmick: channel stuffing (pushing excess stock onto distributors to book sales early) or booking revenue that never gets collected and sits in trade receivables.
Our guide to free cash flow shows how to run this check step by step.
2. A maze of related party transactions
In promoter-run Indian companies, value can leak out through opaque related party transactions (RPTs): the listed company buys materials at inflated prices from a private firm owned by the promoter’s family, pays above-market rent on promoter-owned property, or gives unsecured, interest-free loans to group entities.
The forensic check: open the annual report and search (Ctrl+F) for “Related Party Disclosures”. Look for loans and advances to group companies with no clear business reason, large rent or royalty payments to promoter entities, and amounts that grow faster than the business itself.
3. Auditor changes, resignations and qualified opinions
The statutory auditor is the investor’s independent check on the accounts. If an auditor resigns mid-term, especially citing “lack of information”, treat it as a serious warning. Auditors rarely walk away from a client unless they have concerns about signing the accounts.
- What to track: auditor resignations announced on NSE and BSE, and the auditor’s opinion in each annual report.
- Read the opinion closely: a qualified opinion, an adverse opinion or a disclaimer of opinion is a major red flag. Even a clean (unmodified) opinion deserves attention if it carries long “Emphasis of Matter” or “Material uncertainty related to going concern” paragraphs.
4. Ballooning intangible assets and capital work-in-progress
Capitalising costs is a quiet way to lift profits. Instead of charging an expense, such as software development or repairs, to the profit and loss statement, management parks it on the balance sheet as capital work-in-progress (CWIP) or an intangible asset.
- Why it matters: current profit looks higher than it should. Later, when those “assets” turn out to be worth little, the company takes a large write-off (an impairment charge), and the stock often falls sharply.
- What to watch: some capitalisation is legitimate, because Ind AS allows certain development costs to be capitalised. The warning sign is CWIP or intangibles growing year after year while the projects never seem to finish or produce revenue.
5. Margins far above the industry, with no clear reason
If a company reports EBITDA margins of 25% while competitors selling the same product struggle to reach 12%, ask what explains the gap. Without a patent, a dominant brand, a cost advantage or some other real moat, unusually high margins can come from under-reported expenses or liabilities pushed into later years.
To judge whether high returns are genuine, compare them with how much capital the business uses. Our ROE vs ROCE guide explains how.
Frequently asked questions
What is window dressing in a balance sheet?
Window dressing means making the financial statements look better just before the reporting date (for example, 31 March) and reversing it soon after. A company might take a short-term loan so the year-end cash balance looks healthy, or delay payments and push sales into the last week of the year, then unwind it all in April. It sits in a grey area: some of it is merely misleading, and some can amount to misstatement.
How can a retail investor do basic forensic accounting?
Start with the cash conversion cycle (CCC): inventory days + receivable days − payable days. If receivables and inventory grow much faster than sales, the company may be struggling to collect cash or sell its stock. Then read the Notes to Accounts in the annual report, because that is where related party dealings, contingent liabilities and changes in accounting policy are disclosed.
Are all related party transactions bad?
No. Related party transactions are a normal part of business groups, for example group companies supplying one another. The red flag is when they are not at arm’s length, meaning the listed company overpays or undercharges in a way that benefits a promoter-owned entity. Under SEBI’s listing rules, related party transactions need audit committee approval, and material ones also need shareholder approval, so check how they were approved.
Why should I worry about contingent liabilities?
Contingent liabilities are possible future obligations, such as pending tax disputes, lawsuits, or guarantees given on behalf of other companies. They are disclosed in the notes rather than recorded as liabilities on the balance sheet. If they are large compared with the company’s net worth, one adverse ruling or invoked guarantee can do serious damage.
Where can I find out if an auditor has resigned from an Indian company?
Under SEBI’s Listing Obligations and Disclosure Requirements (LODR) Regulations, a listed company must tell the stock exchanges when its auditor resigns, along with the reasons the auditor gave, within 24 hours. You can find these in the “Corporate Announcements” section on the NSE and BSE websites, or through stock screeners that track filings.
The bottom line
No single number proves an accounting problem, but these red flags tell you where to dig. Check that profits turn into cash, read the related party and contingent liability notes, take auditor changes seriously, and question margins and asset growth that the business can’t explain. A few minutes with the annual report can save a lot of money.
This article is for education only. Companies and groups mentioned are examples for illustration and are not recommendations to buy or sell any security.
Please note: This article is for educational purposes only. Nothing here is a recommendation to buy or sell any security, IPO or investment. Do your own research and read all related documents carefully before investing. Disclosures