Identifying Red Flags in the Financial Analysis of a Company.
Let’s begin with looking at some obvious and easily recognizable red flags that should make you stop and rethink your decision to invest in the company.
- Revenues that have been decreasing consistently over time
- A D/E ratio that is consistently increasing
- Cash flows that are volatile
- Extreme fluctuations in the market price of shares
- Any lawsuit against the company that is still pending resolution
These red flags are easy to identify and demand additional analysis. Apart from the ones mentioned above, here are some accounting red flags that you must check while analyzing the financial statements of the company:
1. Over-attractive Financial Results
Do the financial results of the company seem over-attractive or inconsistent? If yes, then you should investigate further and look for consistency in performance or a valid reason for a sudden boost in the financial results.
2. Auditor’s Report to Management
When a company’s financial statements are audited, the auditor tracks all errors and includes the list under the section ‘Summary of Misstatements’ in the Auditor’s Report to Management.
When you are looking at the financial statements of a company, this is an important section to look at.
Sometimes, the management can have a different opinion compared to auditors. Hence, as a prospective investor, you must ensure that you compare the reports and identify any red flags.
3. Unusual Accounting Policies
Sometimes, companies can adopt unusual accounting practices and/or methods, making it difficult for you to compare their performance with their competitors.
These practices may relate to over/under-estimation of assets, valuation of the inventory, reserves creation, expenses relating to the development of the business, profit management through non-profit activities, etc.
4. Changes in Financial Reporting
- Analyze trends in the balance sheet and profit and loss ratios. So, if you see an increasing debt-to-equity ratio, then it can indicate a potential problem in the operation of the company.
- Some large adjustments made late in the year to make amends for the errors and/or inaccurate data
- A significant change in the senior management of the company
You will be able to see the impact of these changes on the financial reporting of the company.
5. Anomalies in the Financials
When you look at the financial statements of a company and find anomalies – numbers that are higher or lower than expected, then it should serve as a red flag. If you find such anomalies, then look at the following aspects:
- Take a look at the profit and loss statement. If you see the ‘Other Expenses’ category very high or a sudden jump in legal fees or an attempt to hide exorbitant travel expenses, then it is a sign of a potential problem.
- While the sales figures are good, but the majority of them are in the last few days of the month or the quarter consistently
- A sudden surge in the value of fixed assets or intangibles – way above expectations indicating that costs are being capitalized
6. Complex Transactions
Sometimes, you might come across transactions that seem highly complex – with internal or external parties. These may seem like transactions that don’t have a sound economic standing.
Such transactions are often used to deceive. Hence, you must treat them as red flags and spend some more time analyzing them.
7. Performance-linked Bonuses
In some companies, the compensation of the management team is tied to the performance of the company. Hence, senior management has a huge incentive to manipulate the results.
Sometimes, the management team is awarded bonuses for the short-term performance of the company. This could lead to decisions that are not beneficial for the company in the long term. Pay close attention to this aspect too.
8. Gross Profit Margin is Increasing, but Sales are Declining
If you see that the company has a trend of increasing profit margins, then you might be inclined to give it a pass. However, it is important to remember that the gross profit margin should never be looked at in isolation.
Always ensure that you look at the sales figures and overheads.
9. Rising Debtors or Inventory
Finally, analyze the debt and inventory to assess the reasons behind an increase in them. Usually, an increase in inventory or debt is a sign of possible bad debt.
Summing Up
Remember, red flags are the potential threats that may lie buried deep within the financial statements of a company.
While most investors are not chartered accountants or financial analysts, following the points mentioned above can help identify these red flags in financial statement analysis. This can ensure that you don’t make any investment decisions in haste.
Happy Investing!
