The Five Rules for Successful Stock Investing 9

Avoiding Financial Fakery

Over time, increases in a company's cash flow from operations should roughly track increases in net income. If you see cash from operations decline even as net income keeps marching upward – or if cash from operations increases much more slowly than net income – watch out. This usually means that the company is generating sales without necessarily collecting the cash, and that's a very good recipe for a blowup down the road.

[...] firms that make numerous acquisitions can be problematic [...]. Aside from muddying the waters, acquisitions increase the risk that the firm will report a nasty surprise some time in the future, because acquisitive firms that want to beat their competitors to the punch often don't spend as much time checking out their targets as they should.

When inventories rise faster than sales, there's likely to be trouble on the horizon. Sometimes the buildup is just temporary as a company prepares for a new product launch, but that's usually more the exception than the rule. When a company produces more than it's selling, either demand has dried up or the company has been overly ambitious in forecasting demand. In any case, the unsold goods will have to get sold eventually – probably at a discount – or written off, which would result in a big charge to earnings.

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