Red Flags

Red flags

1) Declining cash flow: 

• if cash from operations decline even as net income keeps marching upwards or 
• if cash from operations increase much more slowly than net income. 
• AR increased to a large percentage of sales.
• Inventories increase

2) Serial chargers: 

• frequent chargers are an open invitation to accounting hanky panky because forms can bury bad decisions in a single restructuring charge. 
• Poor decisions that might need to be paid for in future quarters all get rolled into a single one-time charge in the current quarter, which improves future result.

3) Serial acquirers: 

• acquisitive firms don’t spend as much time checking out their targets as they should.

4) CFO or auditors leave the company: 

• If a company fires its auditors after some potentially damaging accounting issue has come to light, watch out.

5) The bills aren’t being paid:  

• One way to pump up its growth rate is to loosen customers’ credit terms, which induces them to buy more products or services. 
• If they don’t get paid, it will come back to haunt them in the form of a nasty write-down or charge against earnings. 
• Track how A/R are increasing relative to sales. 
• On the credit front, watch the ‘allowance for doubtful accounts’. 
• If the amount doesn’t move up in sync with A/R, the company may be artificially boosting its results by being overly optimistic about how many of its new customers will pay its bill.

6) Changes in credit terms and account receivable: 

• Check the company’s 10-Q filing for any mentions of changes in credit terms for customers, as well as for any explanation by management as to why A/R has jumped. 
• ( Look in the management’s discussion and analysis section for the latter and in the accounting footnotes for the former.)

7) Gains from investments: 

• an honest company breaks out these sales, however, and reports them below the ‘operating income’ line on its income statement. 
• The problem arises when companies try to boost their operating results- performance of their core business-by shoehorning investment income into other parts of their financial statements. 
• Finally, companies can hide investment gains in their expense accounts by using them to reduce operating expenses, which makes the firm look more efficient than it really is.

8) Pension pitfalls: 

• If assets in the pension plan don’t increase quickly enough, the firm has to divert profits to prop up the pension. 
• To fund pension payments to future retirees, companies shovel money into pension plans that then are invested in stocks, bonds, real estate, and so forth. 
• If a company winds up with fewer pension assets than pension liabilities, it has an underfunded plan, and if the company has more than enough pension assets to meet its projected obligations to retirees, it has an overfunded plan. 
• To see whether the company has an over-or underfunded pension plan, go to the footnotes of a 10-K filling and look for the note labeled ‘pension and other postretirement benefits’, ‘employee retirement benefits’, or some variation. Then look at the line labeled ‘projected benefit obligation.’ This is the estimated amount the company will owe to employees after they retire.
• Second key number is ‘fair value of plan assets at the end of year’. If the benefit obligation exceeds the plan assets, the company has an underfunded pension plan and is likely to have shovel in more money in future, reducing profits.
• Pension padding: When stocks and bonds do really well, pension plans go gangbusters. And if those annual returns exceed the annual pension costs, the excess can be profits. Flowing gains from an overfunded pension plan through the income statement is a perfectly legal practice that pumped up earnings at GE. You should subtract it from net income when trying to figure out just how profitable a company really is.
• To find out how much profits decreased because of pension costs or increased because of pension gains, go to the line in the pension footnote labeled either ‘net pension/postretirement expense’, ‘net pension credit/loss’. 
• Companies usually break out the contribution of pension costs to profits for the trailing three years; therefore, you can see not only the absolute level of pension profit or loss, but also the trend. Won’t see these numbers in the income statement.

9) Vanishing cash flow: 

• you can’t count on cash flow generated by employees exercising options.  
• The amount is labeled ‘tax benefits from employee stock plan’ or ‘tax benefits of stock options exercised’ on the statement of cash flows. 
• When employees exercise their stock options, the amount of cash taxes their employer has to pay declines. 
• If the stock price takes a tumble, many people’s options will be worthless and, consequently, fewer options will be exercised. 
• Fewer options are now exercised, the company’s tax deduction gets smaller, and it has to pay more taxes than before, which means lower cash flow. 
• If you are analyzing a company with great cash flow that also has a high flying stock, check to see how much of that cash flow growth is coming from options-related tax benefits.

  

10) Overstuffed Warehouses: 

• When inventories rise faster than sales, there is likely to be trouble on the horizon.  
• Sometimes buildup is just temporary as a company prepares for a new product launch, usually exception.

11) Change is bad: 

• another way firm can make themselves look better is by changing any one of a number of assumptions in their financial statements. 
• Look skeptically on any optional change that improve results. 
• One item that can be altered is depreciation expense (see if extend depreciation period). 
• Firms can also change their allowance for doubtful accounts. 
• If it doesn’t increase at the same rate as accounts receivable, a firm is essentially saying that its new customers are much more creditworthy than the previous ones-which is pretty much unlikely. 
• If the allowance declines as AR rises, the company is stretching the truth even further. Current results are overstated. 
• Firms can also change things as basic as how expenses are recorded and when revenue is recognized.

12) To expense or not to expense:  

• Company can fiddle with their costs by capitalizing them. 
• Any time you see expenses being capitalized, ask some hard questions about just how long that ‘asset’ will generate an economic benefit.

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