Related-party transactions refers to a deal or arrangement made between two parties who are joined by a preexisting business relationship or common interest. Companies often seek business deals with parties with whom they are familiar or have a common interest.
Although related-party transactions are themselves legal, they may create conflicts of interest or lead to other illegal situations. Public companies must disclose these transactions.
A company may enter into a deal with another company which may have the same promoter. As a minority investor, it is necessary to ensure that the interests of the investor are not adversely impacted because of such a deal. A few things one must observe is that the transaction is done fairly with the related party with similar and competitive terms as the company would have done externally. Also, the monetary terms of the deals are not adverse for the transacting company.
Some of the things a company with bad governance may do in a related party transaction:
a. Offer better rates or other economic benefits
b. Offer higher credit or do cash transfers
c. Sell or buy products/ subsidiaries or even businesses at a price which may hurt the minority shareholders.
d. Do transactions which may not impact the P/L but may adversely impact the balance sheet (increase liabilities) or cash flows (provide longer credit, write off inventories)
As an investor, one must be very vigilant of related party transactions. The same has to be shared in the annual report of the company.
For analysis on companies – please click here
