Red flags in financial statements

Financial statement fraud, commonly referred to as “cooking the books,” involves deliberately overstating assets, revenues, and profits and/or understating liabilities, expenses, and losses.

Investors rely on quarterly or annually results produced by a company. Company management know that special attention is paid to these results and some of them may do everything they can to achieve the desired results. Sometimes those actions are fraudulent.

Every company maneuvers the numbers to a certain extent to achieve budgets. This is nothing new. But sometimes companies take the fact-fudging too far.

Description of Financial Statement Fraud

Manipulating Timing

Early Recognition of Revenues: bringing revenues from a later period into the current period, increasing revenues for the current period. One way to accelerate revenue is booking lump-sum payment, as current sales when services will be provided over a number of years.

Postponing Expenses: delaying booking expenses to the next period, decreasing the expenses and raising profits for the current period.

Manipulating liabilities and expenses

Postponing Expenses: delaying booking expenses to the next period, decreasing the expenses and raising profits for the current period.

Large “other” expenses on the balance sheet: Many organizations have “other expenses” that are inconsistent or too small to really quantify, which is normal across income statements and balance sheets. If these “other” line items have high values, then you should find out what they are specifically, if you can. You’ll also want to know if these expenses are likely to recur.

Other important factors to watch out for:

Pledged promoters stake: Except for few cases when promoters have good brand name or group backing (eg Bajaj Corp), as a rule of thumb, I do not look at companies with pledged promoters holding. If pledge is for some genuine reason for company expansion etc then my belief is that, over time, promoters will slowly start releasing their stakes from pledge and that is the time I would look at stock.

Low promoters stake: Promoter stake less than 50% is not a good sign. I do not really stick to 50% as a norm but really low stake is a point of concern. However, if promoter stake is really low with order book and cash flow is good then it can also be a takeover candidate.

Several years of revenue trending down: If a company has three or more years of declining revenues, it is probably not a good investment. While cost-cutting measures—such as wasteful spending and reduction in headcount—can help to offset a revenue downturn, it probably won’t if the company has not rebounded in three years.

Rising debt-to-equity ratio: This indicates that the company is absorbing more debt than it can handle A red flag should be raised if the debt-to-equity ratio is over 1 (100%). 

Regular dividends: Again, as a rule of thumb, I am generally more comfortable with companies making profit and sharing it with shareholders in the form of dividend or buybacks specially for market/countries where things can be manipulated with relative ease.

Rising outstanding share count: The more shares that are available for purchase in the stock market, the more diluted shareholder’s stake in the company becomes. If a company’s share count is rising by two or three percent per year, this indicates they are selling more shares and diluting the organization’s value.

Decreasing gross profit margin: As this measures a company’s ratio of profits earned to costs over a set period of time, a declining profit margin is cause for alarm. The profit margin must account not only for the costs to produce the product or service, but the additional money needed to cover operating expenses, such as costs of debt.

Rising accounts receivable or inventory in relation to sales: Money that is tied up in accounts receivable or has already been used to produce inventory is money that cannot generate a return. While it’s important to have enough inventory to fulfill orders, a company doesn’t want to have a significant portion of its revenue sitting unsold in a warehouse.

Loans to executives or other related parties that are written off.

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