MarketShots
Search00 XP1

Fundamental analysisModule 7, lesson 39 of 48

Related-party transactions

What related-party transactions are, where they are disclosed, how they are approved, and the patterns that suggest value is leaking from a company to insiders.

6 min read
Intermediate
Updated

In this lesson

  • Define related parties and related-party transactions.
  • Find related-party disclosures in the notes and judge their size.
  • Explain how larger related-party transactions are approved.
  • Recognise patterns that suggest value is being transferred to insiders.

Builds on

On this page
  1. In simple terms
  2. Where they are disclosed
  3. How they are approved
  4. Judging related-party transactions
  5. Warning signs
  6. Why it matters
  7. Limitations
  8. Common mistakes
  9. Try it yourself

In simple terms

A related party is someone with a close connection to the people who control a company: its promoters, directors and key managers, their relatives, and businesses they own or control. A related-party transaction is any dealing between the company and such a person or business: buying from them, selling to them, renting their property, lending to them, paying them royalties or fees.

Related-party transactions are legal and often sensible. Group companies may supply each other efficiently. But they carry an obvious risk: the controllers sit on both sides of the deal, and could set terms that move value from the listed company, where they own only part, to businesses where they own all.

Where they are disclosed

The notes to accounts include a related-party note listing each related party, the type of relationship, the transactions during the year and the balances outstanding at year-end. The notes lesson shows how to find it. The corporate governance report and exchange filings also give information on approvals.

How they are approved

SEBI's listing rules require related-party transactions to be approved by the company's audit committee. Larger, material transactions also need approval by shareholders, and the related parties involved cannot vote on them. The details, such as what counts as material, are set out in the regulations and change from time to time.

Approval does not guarantee fair terms; it creates a process in which independent directors and minority shareholders can object.

Ask four questions.

  1. How big are they? Compare them with revenue, purchases, profit and net worth. Small, routine dealings are rarely a concern; large ones deserve study.
  2. What is the trend? Rapid growth in related-party dealings is a warning sign.
  3. Are the terms fair? Are prices and credit terms similar to those with unrelated parties, at "arm's length"?
  4. What is the purpose? Is there a clear business reason, or does the arrangement mainly benefit insiders?

Worked example: A made-up company's related-party note

Ganga Textiles' related-party note shows, in ₹ crore:

TransactionThis yearThree years ago
Purchases from a yarn mill owned by the promoter420180
Total purchases1,4001,200
Loans to a promoter-owned real estate company1500
Rent paid to a promoter family trust1210
Net profit90110

Purchases from the promoter's mill grew from 15% to 30% of all purchases, while profit fell. A new loan of ₹150 crore, more than a year's profit, went to an unrelated real estate business owned by the promoter. Both deserve hard questions: are the yarn prices fair, and why is the company lending to a property developer?

Warning signs

  • Loans, advances and guarantees to group companies, especially ones outside the company's business.
  • Royalties or brand fees paid to the promoter's private companies, particularly when they rise faster than sales.
  • Purchases or sales at unusual prices, or with unusually long credit given to related parties.
  • Buying assets from, or selling assets to, related parties at prices that are hard to verify.
  • Complex webs of group companies that make the flows hard to follow, covered in the group structures lesson.
  • Large balances owed by related parties that are not repaid.

Why it matters

Related-party transactions are one of the most common ways that minority shareholders lose out in companies with controlling owners. A business can be growing and profitable, but if a large part of its value flows to insiders through related-party dealings, outside shareholders may never benefit. They are also a common feature of corporate frauds, where money is moved out through group companies.

Limitations

Disclosure shows what happened, not whether the terms were fair, and outsiders rarely have the information to check prices precisely. Many related-party dealings are entirely legitimate. A judgement requires context: the industry, the group's history and how the company treats minority shareholders in other ways.

Common mistakes

  • Assuming all related-party transactions are wrong, or that all are harmless.
  • Ignoring them because they are approved.
  • Looking at one year rather than the trend.
  • Missing loans and guarantees, which can be the largest exposures.

Try it yourself

  1. Find the related-party note in a listed company's latest annual report.
  2. List the main transactions and balances, and compare each with revenue, purchases and net profit.
  3. Repeat for the annual report from three years earlier, and note any rapid growth.
  4. Write down any transaction you would ask management to explain, and why.

Key takeaways

  • A related-party transaction is any dealing between a company and people or businesses connected to its controllers, such as promoters, directors, their relatives and companies they control.
  • They are legal and often normal, for example buying from a group company, but they create a risk that terms favour insiders over minority shareholders.
  • They are disclosed in the notes, and larger ones need approval by the audit committee and by shareholders, with the related parties unable to vote.
  • Warning signs include large or growing amounts relative to revenue or profit, loans and guarantees to group companies, royalties paid to the promoter, and terms that look unusually generous.
  • Judge size, trend, pricing and purpose, not just whether the transactions exist.

Check your understanding

A made-up company pays a royalty of 4% of its sales to a firm owned by its promoter for the use of a brand name. Its net margin is 8%. Why might minority shareholders be concerned?

Finished reading?

Your progress is saved only in this browser.

Module testGovernance, capital allocation and red flags10 questions, explanations for every answer Practice modePlay quick questionsInstant feedback, XP for every right answer

Terms used in this lesson

Related-party transaction
A deal between a company and a party closely connected to it, such as a promoter, director, their relatives or a group company.
Promoter
In India, the founders or controlling shareholders of a listed company, together with their family and related entities.
Corporate governance
The rules, structures and behaviour that make sure a company is run in the interest of all its shareholders, not just those in control.

References

  1. SEBI (Listing Obligations and Disclosure Requirements) Regulations, 2015 (as published, with amendment notes), Securities and Exchange Board of India. SEBI's listing regulations, which set approval and disclosure requirements for related-party transactions.

Spotted a mistake or something unclear? Report it by email. Here is how corrections work.

This lesson is general education, not investment advice. Examples use made-up or clearly dated figures to explain ideas; they are not recommendations. Read the disclaimer.