IPO boom and emerging accounting risks: Key considerations for institutional investors

Accounting quality has always had a strong bearing on investment returns. Set-backs from famous accounting blow-ups like Satyam, IL&FS, etc. brought a string of regulatory changes like mandatory rotation of auditors, stringent requirements on the composition of boards, setting up of the National Financial Reporting Authority (NFRA), etc. India Inc. witnessed rapid adoption of better accounting and governance practices.

Previous accounting blow-ups had two common characteristics 1) These companies particularly resorted to high leverage and 2) there were allegations of siphoning of money (e.g. unwarranted, inefficient capex). However, the strengthening governance landscape and the current scenario of excess capital availability have brought both positive and negative changes to the accounting risks. Accounting quality risks have taken a different avatar in recent times

On the positive side, both investors and corporates are aware of the disastrous effects of disregarding good governance; however, on the negative side, as excess liquidity provides the opportunity for significant market cap rerating, it also motivates accounting gimmicks which are different from the previous ones. Look out for earnings manipulation and high related party transactions risks.

In several instances, there was impressive revenue and profitability growth in the backdrop of volatile or low cash conversions. While achieving growth required incremental investments in working capital, low cash conversions over a considerable period of time could highlight management or timing of profitability. Median cash conversion of recent IPOs (CY21-24) was 65% vs 89% for IPOs over CY13-20, suggesting potential aggressive earnings booking. 74 companies (ex. BFSI) have filed DRHPs till 31 Dec 24. 33 out of these 74 companies witnessed cash conversions (3yr cumulative pre-tax CFO/EBITDA) of <50% in FY24.

Taking cues from IPOs that came for listing in the last 11 years, one could notice an interesting trend. Until the year of listing, most of the IPO companies had showcased significant sales and EBITDA growth, however after listing, the growth rate significantly reduced. Interestingly cash conversions (pre-tax CFO/EBITDA) of these companies were at their lowest when the company witnessed impressive sales/EBITDA growth and only increased as growth rates normalized

A company’s accounting profits should ideally translate into cash flows. A low ratio (i.e. CFO/EBITDA significantly less than one) should raise concerns about the practices followed by the company; these could include: 1) adopting aggressive revenue recognition techniques like channel stuffing and booking revenue in advance (i.e. even before the goods are actually delivered to customers) and 2) elevated credit period offered to customers in anticipation of booking higher revenues etc.

Further, First-level screening of their DRHPs suggests that several companies are getting penalized for high RPT transactions and high off-balance sheet risks. Investors should keep track of these ratios to rule out any further worsening. Key observations include 1) 23 out of 74 companies have high contingent liabilities as a % of net worth (>20% of net worth on a 3 yr. median basis) 2) Surprisingly, 17 companies have a gross cash outflow of >5% of FY24 revenue to the promoter entities.

One should be particularly aware of these possible accounting pits in upcoming IPOs.

(The author Nitin Bhasin is Head of Institutional Equities at Ambit. Views are own)

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