Management, governance and business quality
The answer
Financial ratios describe decisions that have already been made. Management makes the decisions that produce the next 10 years of ratios, and the largest of those decisions is what to do with the company's cash.
You judge management from published evidence, not from interviews: their record of capital allocation, the related-party transactions note, the auditor's fee table, and what they promised 5 years ago compared with what happened.
Why this costs you money
You own a company with excellent numbers. Return on capital of 22%, no debt, growing revenue. Over the next 6 years the numbers get worse and you cannot see why in any single year.
What happened was a series of decisions, each small enough to ignore.
The company bought an unrelated business at a high price, using cash it had built up. Return on capital fell 2 points. It paid a royalty to a private entity owned by the controlling family for the use of a brand, rising every year. It leased its head office from another entity owned by the same family. It gave loans to a subsidiary that never repaid them. It paid its chief executive an amount that grew whether profits grew or not.
None of these appears as a line called "value destroyed". Each is disclosed somewhere in the annual report, in a note most readers skip.
The compounding cost is the point. A company earning 22% on capital that reinvests well doubles the capital's earning power roughly every 3 to 4 years. A company earning 22% that reinvests at 8% converts its best asset into an average one, quietly, over a decade. You will hold it the whole time, because the share price falls slowly and the reported profit still rises.
The second cost is faster and larger. Where governance fails badly, the loss is not gradual. The share falls 40% to 90% in weeks, on an announcement, and the warning signs were in the disclosures for years.
How it works
Capital allocation is the job
A company generates cash. There are exactly 5 things it can do with it.
- Reinvest in the existing business — new capacity, new products, new markets.
- Acquire another company.
- Repay debt.
- Pay a dividend.
- Buy back its own shares.
Every chief executive makes this choice every year, and over a decade the cumulative effect of those choices matters more than almost anything else. The test is simple to state: did each rupee retained by the company produce more than a rupee of value?
You can check this yourself. Take a 10-year period. Add up all the profit the company retained rather than paid out. Then look at how much the company's earnings power rose over the same period. If a company retained ₹5,000 crore and its annual operating profit rose by ₹300 crore, the retained money is earning about 6%. You could have earned more in a bank deposit, and it was your money.
Acquisitions are where most value is destroyed. Watch what happens to return on capital employed in the 3 years after each large acquisition. If it falls and does not recover, the company paid too much. Watch also for goodwill that keeps growing and is never written down.
Governance is about who the company is run for
Governance is not a moral question. It is a structural one: when the interests of the people controlling the company differ from the interests of ordinary shareholders, what stops them acting on it?
The conflict has 2 different shapes, and which one you face depends on the market.
Where ownership is dispersed and no single shareholder controls the company, the conflict is between professional managers and shareholders. Managers may pay themselves too much, build an empire, or take risks that benefit them and not owners.
Where a founding family or group holds a controlling stake, the conflict is between the controlling shareholder and the minority shareholders. The controlling shareholder cannot take money as a dividend without paying it to everybody, so the value can move through other routes: related-party transactions, royalties, leases, loans.
The 6 checks that use published data
1. Related-party transactions. A mandatory note in the annual report. It lists every transaction with entities connected to the directors or the controlling shareholders — sales, purchases, royalties, rent, loans, guarantees, remuneration. Read the whole note. Then ask 1 question about each material item: does this transaction have an obvious commercial reason that could not be achieved with an unconnected party?
2. The auditor's remuneration. Also a mandatory disclosure, usually a small table in the notes. It splits the auditor's fees into audit fees and other services — tax advice, consulting, certification. If non-audit fees are large relative to audit fees, the auditor has a commercial relationship with management that is bigger than the audit itself. That does not prove anything, and it changes the incentive.
3. Executive pay against profit. Track total director and key management remuneration over 5 years alongside profit. Pay that rises while profit falls is a statement about whose company this is.
4. Promoter or insider holding, and pledging. A falling controlling stake deserves an explanation. Shares pledged as collateral for loans are worse, because a falling share price can force a lender to sell them, which pushes the price down further.
5. The board. How many directors are genuinely independent. Whether the same person is chairman and chief executive. How long the independent directors have served — an independent director of 18 years is not obviously independent. Who chairs the audit committee.
6. What they said, against what happened. This is the most valuable and the least done. Download the annual report from 5 years ago. Read the chairman's or chief executive's letter. Write down every specific promise: a margin target, a capacity expansion, a new market, a debt reduction. Now check each one against what actually occurred. Management teams differ enormously on this and almost nobody measures it.
Business quality is separate from management quality
A good business can survive mediocre management for a long time. A poor business will exhaust a good manager.
The signs of a durable business: return on capital employed that stays high for 10 years rather than 2; the ability to raise prices without losing customers; low customer concentration; and a reinvestment runway, meaning the company can put more money to work at similar returns.
The signs of a fragile one: returns that only appear at the top of a cycle; dependence on 1 customer, 1 regulator or 1 subsidy; and a business where the company must keep spending to stay in the same place.
What it tells you, and what it does not
These checks tell you whether the value the business creates is likely to reach you. That is a different question from whether the business creates value, and it is the question ratios cannot answer.
They do not predict fraud. Good governance structures have coexisted with major frauds, and companies with weak-looking governance have delivered excellent returns for decades. The relationship is probabilistic, not mechanical.
They also do not tell you a company is uninvestable. A controlling family with significant related-party dealings is a reason to demand a lower price, not automatically a reason to refuse. Every governance concern has a price at which it is compensated. The failure is paying a premium multiple as though the concern did not exist.
The largest limitation is that the disclosure describes form, not substance. An independent director is independent by the definition in the regulation. Whether that person will oppose the chairman in a difficult meeting is not disclosable. The most useful evidence is behavioural: what the board did the last time there was a conflict.
The decision rule
Read the related-party note before the ratios. If value can leave the company through a side door, no ratio computed at the front door means what you think it means.
The conditional on related-party transactions. Related-party transactions that are small, disclosed, commercially explainable and stable over time are usually fine — unless they are growing faster than revenue, in which case an increasing share of the company's economics is moving to entities you do not own.
The conditional on capital allocation. A company retaining most of its profit is doing the right thing if return on capital employed has stayed high while it did so — unless the returns are being maintained by an old business while the newly invested capital sits in a segment earning much less. Check the segment data, where it exists.
The conditional on the auditor. A long-serving auditor is a sign of stability — unless non-audit fees are large, or the auditor was replaced without a clear reason, or the previous auditor resigned mid-term. In those cases the accounts should be treated as unverified until a new firm has signed a full year.
Hard rule. Where a controlling shareholder has pledged a substantial part of their holding, position size should be smaller than your conviction suggests, because the risk is not only about the business. It is about a forced seller appearing at the worst moment.
Try this now
Five minutes, 1 holding you own. Download the latest annual report from the company's website or from the NSE, BSE or SEC filing page.
- Open the notes to the financial statements and find the note titled related-party disclosures or related-party transactions. In a US filing, look for certain relationships and related transactions in the proxy statement or the 10-K.
- Read the whole note. Write down the 3 largest transactions by value, and who they are with. Look specifically for royalty, rent, loans and advances given, guarantees given, and sales to or purchases from related entities.
- Add up the total value of related-party transactions and divide it by revenue. Write down the percentage.
- Now find the note on auditor's remuneration or payments to the auditor. In a US proxy statement it is a table headed audit fees, audit-related fees, tax fees and all other fees. Write down the audit fee and the total of everything else.
- Divide non-audit fees by audit fees.
What you should see. Three things, and they take longer to think about than to find.
Most companies have related-party transactions and most are ordinary — a subsidiary selling to its parent, directors' salaries, a group treasury arrangement. What you are looking for is a transaction with an entity that is not consolidated into the accounts you are analysing. Money moving to an entity you do not own is money leaving your investment.
If you find a royalty payment to a privately held entity owned by the controlling family, check whether it is a fixed amount or a percentage of revenue, and check how it has changed over 5 years. A royalty rising faster than profit transfers an increasing share of the business.
On the auditor, most companies will show non-audit fees well below audit fees. If non-audit fees exceed audit fees, note it. It is not evidence of wrongdoing. It is a reason to read the auditor's report more carefully, and to weight the key audit matters more heavily than you otherwise would.
Three real cases
1. Infosys, August 2017 (India) — a governance dispute at a company with strong governance Infosys had for years been regarded as among the best-governed large Indian companies. From 2016 onward a public disagreement developed between founders and the board, centred on the acquisition of the Israeli automation company Panaya and on a severance payment made to a departing chief financial officer. Whistleblower complaints followed. Chief executive Vishal Sikka resigned on 18 August 2017 and the share price fell sharply on the announcement. Nandan Nilekani returned as non-executive chairman on 24 August 2017. The company's operations were not in question at any point. The dispute was entirely about who decides and how decisions are explained, and it cost shareholders real money within days.
2. Tata Sons and Cyrus Mistry, October 2016 to March 2021 (India) — control in a group structure Cyrus Mistry was removed as chairman of Tata Sons, the holding company of the Tata group, on 24 October 2016. The dispute moved through the National Company Law Tribunal and the appellate tribunal, and the Supreme Court of India ruled in favour of Tata Sons on 26 March 2021. The litigation turned in part on the rights of a large minority shareholder in a company controlled by trusts. Shares of several listed Tata group companies moved on developments in the case. For a minority shareholder in any group structure, the lesson is that control sits above the listed entity you own, and disputes at that level reach your holding.
3. Wells Fargo, September 2016 to February 2018 (United States) — incentives that produced the behaviour they rewarded On 8 September 2016 the Consumer Financial Protection Bureau, together with other regulators, announced enforcement action against Wells Fargo including a penalty of $185 million, over the opening of a very large number of deposit and credit card accounts without customer authorisation. Employees had faced aggressive sales targets. Chief executive John Stumpf resigned on 12 October
- In February 2018 the Federal Reserve imposed a restriction on the bank's
asset growth until governance improvements were made. The bank's board was independent by every formal measure. The failure was in the incentive structure, which is a governance matter that no board composition table discloses.
The question that resolves it
A novice reads the annual report and asks: is this a good company?
An expert reads the same report and asks: when the controlling shareholder's interest and mine differ, what has this company actually done?
The evidence for that is behavioural and historical. It is in the related-party note, the capital allocation record, and what happened the last time there was a conflict.
What would make this wrong
If governance quality reliably predicted returns, then a portfolio of the best-governed companies would beat the market consistently. It does not, over all periods. Companies with concentrated family control and significant related-party dealings have delivered excellent long-run returns, and some of the best-governed large companies have delivered poor ones. Governance is a risk factor, not a return factor.
The specific limits worth stating.
Disclosure measures form. Board independence, committee composition and policy documents are all checkable, and all of them can be satisfied by a company whose real decisions are made elsewhere.
Related-party transactions are often entirely legitimate. Group companies transact with each other for good operational reasons. Treating every related-party transaction as a warning will exclude a large part of the Indian market for no gain.
The non-audit fee test is weak on its own. It is a reason to look harder, not a finding. Plenty of companies with high non-audit fees have clean accounts.
Judging management from letters is unreliable. Chief executives are selected partly for their ability to communicate confidently. The written record of what they promised is better evidence than the tone of what they write, which is why the 5-year promise check is worth more than reading this year's letter closely.
And the largest honest problem: the governance concern that matters most is usually the one nobody has written down yet. Every case in this article was visible only after it happened, and reading the disclosures beforehand would have raised a question, not produced an answer.
In India
The regulatory framework is genuinely strong on paper. SEBI's listing regulations set board composition requirements, including a minimum proportion of independent directors that rises where the chairman is an executive or related to the promoter. The Companies Act, 2013 governs related-party transactions under section 188, audit committees under section 177, managerial remuneration limits under section 197, and auditor rotation under section 139.
Related-party approval requires the minority to decide. Material related-party transactions require shareholder approval, and related parties cannot vote on the resolution. This means the minority shareholders alone decide. It is one of the stronger minority protections in any large market, and it is the reason these resolutions are worth reading before you vote. Voting is electronic and takes a few minutes.
Promoter control is the norm, and that changes what governance analysis means. In a company where a family holds 50% or more, the board cannot remove them and no acquirer can outbid them. The realistic protections are disclosure, the audit committee, the minority vote on related-party transactions, and the regulator. Your analysis should therefore focus on where money can move, not on whether the promoter could be replaced.
Promoter pledging is disclosed quarterly in the shareholding pattern filed with the exchanges. It has preceded a striking number of Indian corporate failures and it is free to check.
Royalty payments to promoter-owned entities are common in India, including at subsidiaries of foreign parents that pay a royalty for brand and technology. SEBI has required shareholder approval where royalty payments to related parties exceed a specified percentage of consolidated turnover. Check the percentage and its trend.
Sustainability reporting. SEBI requires the largest listed companies by market capitalisation to file a Business Responsibility and Sustainability Report . It is a useful source for workforce, safety and governance data in a standard format.
In the United States
The proxy statement is the governance document, filed as form DEF 14A ahead of the annual meeting. It is more readable than the 10-K and it contains most of what you need: the full executive compensation tables, the structure of incentive plans, board members and their other commitments, the audit fee table, and the related-transactions disclosure under Item 404.
Shareholders vote on pay. The Dodd-Frank Act introduced a periodic advisory vote on executive compensation, commonly called say-on-pay. It is advisory, so a board can ignore it, but a large negative vote is a public signal and boards generally respond.
Internal controls are certified. Under the Sarbanes-Oxley Act of 2002, the chief executive and chief financial officer must personally certify the accounts, and management must assess the effectiveness of internal control over financial reporting, with an auditor attestation for larger companies. A disclosed material weakness in internal controls is a specific, checkable warning.
Auditor changes are filed promptly on form 8-K, and the filing must state whether there were disagreements with the former auditor.
Dual-class share structures are the main US control issue. A founder can hold shares carrying 10 or more votes each while owning a small economic share of the company. The economic effect resembles Indian promoter control, but it is created by share structure rather than by holding size, and it is disclosed in the proxy statement.
Clawback of incentive pay after a restatement is now required under listing standards adopted following SEC rulemaking.
Where they differ, and what that tells you
The conflict you are protecting yourself against is different in each market, so the pages you read are different.
In the United States, ownership of most large companies is dispersed. The classic risk is that professional managers act for themselves — overpaying themselves, overpaying for acquisitions, protecting their position. So the highest-value reading is the proxy statement: how pay is structured, what targets it is measured against, and how the board responded to the last say-on-pay vote.
In India, most listed companies have a controlling family. The classic risk is that value moves from the listed company to entities the family owns privately. So the highest-value reading is the related-party transactions note, the royalty disclosure, the promoter pledge percentage, and the loans and advances given.
Applying the wrong checklist leaves a real gap. An Indian reader who scrutinises executive pay while skipping the related-party note has checked the smaller risk. A US reader who scrutinises related-party transactions while skipping the compensation structure has done the same in reverse.
One Indian protection is stronger than its US equivalent. Excluding related parties from the vote on material related-party transactions gives Indian minority shareholders a genuine decision on the exact transactions that threaten them most. The US does not have a general equivalent for controlled companies, and companies with dual-class structures can be largely insulated from shareholder votes altogether.
One US disclosure is stronger. Segment reporting and the compensation discussion together let you see which business produced the results that triggered the bonus. Indian disclosure rarely allows that link to be made.
Carry this
- Capital allocation is the job. Over 10 years, what management did with the cash matters more than any single year's numbers.
- Read the related-party note before the ratios. Value that leaves through a side door never appears in a ratio.
- Compare what management promised 5 years ago with what happened. It is the cheapest and most honest test of a management team that exists.