1) Red Flags for Financial Analysis

In today's newsletter we go over some of the big red flags that analyst's should be vigilant of when studying the financial filings of a company.

In an effort to discover misleading, or even fraudulent, accounting https://investmenttalk.substack.com/p/red-flags-for-financial-analysis?r=66q6l&utm_campaign=post&utm_medium=web&utm_source=copy

2) We cover:

- Relative Revenue Performance
- CFO vs NI
- Funky Margins
- Non-Recurring Items
- Inventories
- Methods of Depreciation
- Lumpy Earnings and Smoothing
- Disclosure
- Culture
- Acquirer's Addiction

3) For flavor, lets discuss relative revenue performance:

The very top line within the income statement is, of course, the revenue of the firm during the reported period, otherwise known as the ‘top line’.

4) It is important to remember here, that income statements are reported on an accrual basis, in that they report sales and expenses when they are incurred, and not necessarily when the goods or cash exchange between parties.

There is a lot of discretion placed here.

5) Top line growth is cool, but it is not the only thing we should concern our analysis with when addressing the income statement. Let us now run through a couple of things we can consider to scan for inconsistencies in the reporting of revenues.

6) By this, i simply mean assess the company’s revenues against that of their competition.

- How does the company’s revenue growth compare to rivals?

7) There are certain companies who may exhibit revenue growth rates that are fairly detached from the rates displayed by their competition. This in itself is not a red flag per se, but we should seek to understand why the disparity exists.

8) The superior top line growth may be a matter of superior product offering, technology, moat, management, cost leadership etc. One example may crop up when comparing a relatively new company in a given market, utilizing a technology that incumbents are not.

9) The growth rates of top line may be excessive in comparison, whilst the new technology is being adopted.

So seeking to understand why the disparity is key here. If we have a why then we need not worry.

10) However, in the case of no why, we can’t just assume that the top line growth is down the management or some other factor we are unaware of. Some extra due diligence is required.

11)An extra step we can take is to examine the level of receivables over time, and observe the relationship between revenues and the receivables.

Recall that income statements are based on accrued.

12) So if we make a sale, it gets recorded as a sale regardless of the cash being collected or not. If we do not receive cash at the point of sale, then we place it on the balance sheet in the receivables line item.

13) If, over time, the level of receivables as a percentage of revenues is increasing, then we it may be the act of fictitious sale reporting, or channel-stuffing to artificially bolster the top line figure.

14) It can also be useful to calculate (or simply pull the data for) the receivables turnover over a period of time too.

Receivables Turnover = Revenue / Average Receivables

15) This ratio will show us how effectively the company extends credit and collects debts, the higher relative figure being the more efficient. Next, we can compute the Days of Sales Outstanding (DSO).

DSO = Number of Days / Receivables Turnover.

16) The DSO and Receivables number will move in opposite directions of course. So a decrease in the receivables turnover, or an increase in DSO over time, may be further evidence of income statement manipulation

17) By this, i mean that the company may be reporting sales too early (channel stuffing), or even fabricating sales. Assessing this in isolation is not so useful, i would advise comparing these metrics across the industry peer groups.

Luckin Coffee anyone?

18) In addition to assessing the way in which the company reports their receivables, we can also observe the asset turnover.

Asset Turnover = Revenue / Average Total Assets

Asset turnover is a measure of how efficiently revenue is generated from assets.

19) If we see a period whereby the total asset turnover is in continuous decline, then there may be significant write-downs ahead. This is especially true in circumstances whereby companies acquire other companies to grow.

20) In this instance, assets will grow (goodwill and other items), but if revenues do not grow at a faster pace, the total asset turnover will dwindle. A falling ratio indicates worsening capital allocation.

21) As a last point for this segment, it is always useful to compare the accounting policies of the company you are analyzing against the competition. Specifically how they recognize their revenues.

22) You have to consider that some policies will make it easier to manipulate figures in the form of recognition early accounting.

Therefore, it is important to understand how each company records their revenues, and assess what difference this makes in terms of their top line.

23) Imagine if you will, three companies, all similar products. Two report sales at the point of delivery to the consumer, one reports prior to the shipment of goods (using a ‘bill-and-hold’ arrangement).

24) The latter company could, in theory, report a significant amount of sales prior to actually delivering the product. This potentially makes it easy to channel-stuff prior to a quarter-close period.

Be vigilant of these issues.