Ricoh India saga: Avoid direct investments if you aren't doing own research

Ricoh India's impending troubles could only have been spotted by investors willing to dig deep into the financial statements of the company

Through an order dated February 12, 2018, the Securities and Exchange Board of India (Sebi) barred seven key management personnel of Ricoh India from accessing the securities markets. The regulator will also conduct a detailed forensic audit of the company's books to understand the full extent of the accounting scam at the printer seller that later forayed into information technology services (ITS). The scam once again emphasises the need for direct stock investors to develop the ability to spot troubles early through a close reading of financial statements. 

Playing fast and loose with numbers: Through a letter dated April 20, 2016, Ricoh India informed Sebi that a forensic review of its books of account done by PwC India had found that the financial statements for the quarters ended June 30 and September 30, 2015, did not reflect the company’s true position. PwC’s forensic review revealed that unsupported, out-of-book adjustments were made to net sales, expenses, and assets and liabilities, leading to suppression of losses. Revenues were recorded even though there was no transfer of goods to customers. In case of composite contracts, full revenue was recognised even when the contract had been only partially fulfilled. The company's management also engaged in channel stuffing, a method used to inflate revenues, wherein companies sell to select distributors in excess of what they are capable of selling. Emails of key personnel revealed that when the company's new auditors refused to sign on its financial statements, false documents were created to satisfy them.

Most of the misstatement pertained to the company's ITS division. Goods and services were procured from select parties and also sold to them to generate spurious revenues. It was made to appear that the company was making profits through these transactions, whereas in reality it was incurring losses due to non-collection of receivables. These select customers were extended credit without assessing their credit worthiness. Several of them defaulted on their payments subsequently.

Sebi's own investigations revealed that transactions leading to misstatements in the books of account extended from financial year 2012-13 to 2015-16.

The tell-tale signs: Experts say that there were many tell-tale signs that could have alerted vigilant investors to problems at the company. The first, they say, was the rapid revenue growth in the ITS division. The revenue of this new business grew from zero to around Rs 10 billion in four years. Experts say that investors should have enquired how the company was managing to grow so fast in a new category. 

Another issue that should have raised a red flag was the company's acquisition of two small firms when it decided to foray into IT services. "Normally, a company decides to buy another if it can't build up the business by itself. Ricoh India could have created a trading or ITS business, since it enjoys strong brand equity. Where was the need to acquire companies? It wasn't as if these acquisitions gave them a great brand, product or a sticky client base," says Jatin Khemani, founder and chief executive officer, Stalwart Advisors, a Sebi-registered independent equity research firm.

Investors can also spot a potential fraud at a company, say experts, by keeping an eye on accruals. "An easy way to measure accruals is to subtract cash flow from operations (from the statement of cash flows) from the company’s profit or loss from the P&L statement. Increasing accruals can be an early sign of potential problems," says Ramabhadran Thirumalai, senior associate dean-academic programmes and assistant professor of Finance at the Indian School of Business. At Ricoh, accruals in the five years from 2011 to 2015 rose from Rs 250 million to Rs 2.56 billion in 2015. "This is indicative of a large amount of revenues not being in cash. It should have triggered worry among investors," adds Thirumalai.  

The investor could also have checked the company's cash flows from operating activities, which were negative throughout this period. "This again tells you that sales were bogus and were not translating into cash. This is one of the first parameters seasoned investors check in a company," says Khemani. 

In 2011, it was debt-free. Over the next four years, its working capital loans rose, which is understandable given that it was a trading business. But it also took on long-term debt, which didn't make sense, since the business was not capital intensive. From zero in 2011-2012 debt rose to Rs 7 billion, including Rs 2 billion in long-term debt, by 2014-2015. The company's debt-to-equity ratio rose from zero to 4.2 times.

A investor, proficient at reading financial statements, could have spotted these issues and exited the stock. Rest is history.

Key lessons from the Ricoh India saga

• Don't follow celebrity investors blindly. Borrow ideas from them but do your own due diligence 
• Just because a rating agency has given a company a high rating doesn't mean all is well 
• Related-party transactions can take place and yet not show up in the company's annual report because they are well hidden 
• Whether the promoter is an MNC or Indian, scams can happen anywhere