10 red flags in the presentation of financial statements

In this article, we’ll use the information outlined in our analysis of the income statement, balance sheet, and cash flow statement to list the 10 “red flags” to look for. These red flags can indicate that a company may not present an attractive investment based on the three main pillars: growth potential, competitive advantages and sound financial health. On the contrary, a company with few or none of these red flags is probably worth considering.

The red flags, in no particular order, are:

  1. A multi-year trend of declining income.

    While a business can improve profitability by eliminating unnecessary expenses, reducing unnecessary staff, improving inventory management, etc., long-term growth depends on sales growth. A company with 3 or more consecutive years of declining revenue is a questionable investment; any cost efficiencies can generally be achieved during that time period. More often, declining revenue is indicative of a business in decline, which is rarely a good investment.

  2. A multi-year trend of decreasing gross, operating, net, and / or free cash flow margins.

    Declining margins may indicate that a company is bloating or that management is chasing growth at the expense of profitability. This must be taken in context. A declining macroeconomic outlook or a cyclical company can reduce margins without indicating an inherent decline in operations. If you cannot reasonably attribute margin weakness to external factors, be careful.

  3. Excessive increase in outstanding stock count.

    Be wary of companies whose stock count is steadily increasing more than 2-3% per year. This indicates that management is giving away the company and diluting its stake through options or secondary stock offerings. The best case here is looking at the stock count. declining 1-2% per year, which shows that management is buying back shares and increasing its stake in the company.

  4. Increase in debt to equity coverage rates and / or decrease in interest coverage rates.

    Both are an indication that the company is taking on more debt than its operations can handle. Although there are few concrete objectives in investing, take a closer look if the debt / equity ratio is greater than 100% or if the interest coverage ratio is 5 or less. Take a closer look if this red flag is accompanied by a drop in sales and / or a drop in margins. If so, this action may not be in very good financial health. (Interest coverage is calculated as: net interest payments / operating profit).

  5. Increase in accounts receivable and / or inventories, as a percentage of sales.

    The purpose of a business is to generate cash from assets – period. When accounts receivable increase faster than sales, it indicates that customers are taking longer to give you cash for products. When inventories increase faster than sales, it indicates that your company is producing products faster than they can be sold. In both cases, the cash is tied up in places where it cannot generate a return. This red flag can indicate poor supply chain management, poor demand forecasting, and overly flexible credit terms for clients. As with most of these red flags, look for this phenomenon over a period of several years, as short-term problems are sometimes due to uncontrollable market factors (like today).

  6. Free cash to earnings ratios consistently below 100%.

    This is closely related to the previous red flag. If free cash flow is consistently below reported earnings, serious investigation is needed. Usually, increased accounts receivable or inventory is the culprit. However, this red flag can also be indicative of accounting tricks, such as capitalizing purchases rather than recording them as expenses, artificially inflating the number of net earnings in the income statement. Remember, only the cash flow statement shows you discrete cash values; everything else is subject to accounting “assumptions”.

  7. Very large “Other” items on the income statement or balance sheet.

    These include “other expenses” in the income statement and “other assets” / “other liabilities” in the balance sheet. Most companies have them, but the value given to them is small enough not to be a cause for concern. However, if these line items are significant as a percentage of total business, do some deep research to find out what’s included. Are expenses likely to be repeated? Are any of these “other” items murky, such as related party agreements or non-business related items? Large “other” items may be a sign that management is trying to hide things from investors. We want transparency, not cloudiness.

  8. Many non-operating or one-time charges on the income statement.

    Good companies have very easy to understand financial statements. On the other hand, companies trying to cheat or hide problems often bury charges in the “other” categories mentioned above, or add numerous line items for things like “restructuring,” “asset impairment,” “goodwill impairment. “, etc. go ahead. A multi-year pattern of these “one-time” charges is cause for concern. Management will do everything possible to improve non-GAAP or pro-forma results, but there has actually been little improvement. These charges are a way of confusing investors and trying to make things look better than they are. Instead, look at the cash flow statement.

  9. Solvency ratio below 100%, especially for cyclical companies.

    This is another measure of financial health, calculated as (current assets / current liabilities). It measures the liquidity of a company or its ability to meet its obligations during the next 12 months. A running ratio below 100% is not much of a concern for companies that are stable in business and generate a lot of cash (think Proctor and Gamble (PG)). But for highly cyclical companies that could see 25% of their revenue disappear in a year, it’s a big concern. Cyclical relationship + low current = recipe for disaster.

  10. Poor return on equity when adding goodwill.

    This one is specifically aimed at Magic Formula investors. Joel Greenblatt’s go-to-market booklet eliminates goodwill for purposes of calculating return on equity. However, if growth is financed by overpaying for acquisitions, return on equity will look great because the amount of overpayment is not accounted for. MagicDiligence always looks at both measurements, with and without good will. If the “with goodwill” number is low, the MFI’s high return on equity is a mirage.

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