Avoiding Financial Fakery - Six Red Flags
Declining Cash Flow
a. Watch cash flow. Over time, increases in a company's cash flow from operations should roughly track increases in a company's cash flow from operations should roughly track increases in net income.
b. If 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.
c. E.g. Lucent - Between 1997 and 1999, Lucent's net income soared from $449 million, to just over $1billion, to almost $3.5 billion - an incredible growth rate for such a large company. At the same time, however, cash flow from operations was plunging precipitously, from 2.1 billion in 19197 to1.9 billion in 1998, to negative $276 million in 1999. Sordid story boiled down to three reasons
Serial Charges
1. Be wary of firms that take frequent one-time charges and write-downs. This practice makes the historical financials muddier because every charge has a long explanation and usually various components that affect different accounts.
2. Frequent chargers are an open invitation to accounting hanky-panky because firms can bury bad decisions in single restructuring charge.
Serial Acquirers
1. Firms that make numerous acquisitions can be problematic - their financials have been restated and rejiggered so many tomes that's it's tough to know which end is up
2. Acquisitions increase the risk that the firm will report a nasty surprise sometime 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.
The Chief Financial Officer or Auditors Leave the Company
1. When it comes to financial reporting, the watchmen are the CFO and the the corporate auditors. If a CFO leaves the firm you should be on your guard.
2. Same applies to corporate auditors. If a company changes auditors frequently or fires its auditors after some potentially damaging accounting issue has come to light, watch out.
The Bills Aren't being Paid
1. Wall St. loves growth, and companies go to great lengths to keep their top line increasing as rapidly as possible.
2. One of the sneakier to pump growth rate is to loosen customer's credit terms, which induces them to buy more products and services.
3. Companies can also ship out more products than their customers ask for - known as "stuffing the channel" - but this is less common.
4. The loose credit terms are probably attracting financially shakier customers - the pumped-up growth rate will eventually come back to bite the company in the form of nasty write-down or charge against earnings
5. Track how fast A/R are increasing relative to sales - the two should roughly track each other. As a general rule, it's simply not possible for A/R to increase faster than sales for a long time - the company is paying out more money than it's taking in
6. Watch "allowance for doubtful accounts" which is essentially the company's estimate of how much money it wont be able to collect from deadbeat customers. If this 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 their bills.
Changes in Credit Terms and Accounts Receivable
1.Check the company's 10-Q filing for any mentions of changes in credit terms for customers, as well any explanation by management as to why A/R has jumped.
Seven Other Pitfalls to Watch out For
Gains from Investments
Investment income should be reported below "operating income" line on the income statement. The problem arises when companies try to boost their operating results - in other words, the performance of their core business - by shoehorning investment income into other parts of their financial statements
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.
If the firm you're analyzing is using investment gains or asset sales to boost operating income or reduce expenses, you know you're dealing with a company that might be less than forthcoming in other areas as well.
Pension Pitfalls
To see whether the company has an over or underfunded pension plan, go to the footnotes of 10-k filing and look for note labeled "pension and other post retirement benefits"
Pension Padding
Flowing gains from an over funded pension plan through the income statement is perfectly legal practice that pumped earnings (example at GE).
However, this pension-related income is a strange kind of profit, it's not available to pay out to shareholders - it belongs to the pension plan.
Vanishing Cash Flow
Cant count on cash flow generated by employees exercising options. When an employee exercises their stock options, the amount of cash taxes that their employer pays declines.
As long as the firm's stock keep going up and it keeps giving out options, this process continues. More options are exercised, tax deductions are taken and the firm saves cash by lowering its tax bill.
If you're 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.
Overstuffed Warehouses
When inventories rise faster than sales, there's likely to be trouble on the horizon
Change Is Bad
Another way firms can make themselves look better is by changing any one of a number of assumptions in their financial statements. As a very general rule, look skeptically on any optional change.
Check changes to firm's depreciation expense. Longer the depreciation period, the smaller the annual hit to earnings.
Firms can also change their allowance for doubtful accounts. If the allowance for doubtful accounts 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 unlikely. If the allowance actually declines as accounts receivable rise, the company is stretching the truth even further.
To Expense or Not to Expense
Companies can also fiddle with their costs by capitalizing them.
Accrual accounting - benefits have to be matched with expenses. Short term benefit expense, long-term benefit capitalize.
Anytime you see expenses being capitalized, ask some hard questions about how long that "asset" will generate an economic benefit. Looking at the useful life assumption will generally do the trick - a building might be useful for 40 years, but a piece of office furniture or a chunk of software won't.
Investor's Checklist - Avoiding Financial Fakery
1. The simplest way to detect aggressive accounting is to compare the trend of of net income with the trend in cash flow from operations. If net income is growing quickly while cash flow is flat or declining, there's a good chance of trouble lurking
2. Companies that make numerous acquisitions or take many one-time charges are more likely to have aggressive accounting. Be wary if a firm's chief financial officer leaves or if the firm changes auditors
3. Watch the trend of account receivables relative to sales. If accounts receivable is growing much faster than sales, the company may from be having trouble cash from its customers.
4. Pension income and gains from investments can boost reported net income, but dont confuse them with solid results from the company's core operations.
Declining Cash Flow
a. Watch cash flow. Over time, increases in a company's cash flow from operations should roughly track increases in a company's cash flow from operations should roughly track increases in net income.
b. If 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.
c. E.g. Lucent - Between 1997 and 1999, Lucent's net income soared from $449 million, to just over $1billion, to almost $3.5 billion - an incredible growth rate for such a large company. At the same time, however, cash flow from operations was plunging precipitously, from 2.1 billion in 19197 to1.9 billion in 1998, to negative $276 million in 1999. Sordid story boiled down to three reasons
- Lucent extending credit to anyone who could spell photon, which meant it was booking many sales without receiving the cash. A/R ballooned from 20% of sales to 27% between 1997 and 1999, a clear sign that the firm was having trouble collecting money it was owed
- Lucent kept building more gear than it could ship, which sent inventories upward.
- Lucent's pension plan was pumping up net income with noncash gains
d. If you do nothing else, watch cash flow like a hawk
Serial Charges
1. Be wary of firms that take frequent one-time charges and write-downs. This practice makes the historical financials muddier because every charge has a long explanation and usually various components that affect different accounts.
2. Frequent chargers are an open invitation to accounting hanky-panky because firms can bury bad decisions in single restructuring charge.
Serial Acquirers
1. Firms that make numerous acquisitions can be problematic - their financials have been restated and rejiggered so many tomes that's it's tough to know which end is up
2. Acquisitions increase the risk that the firm will report a nasty surprise sometime 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.
The Chief Financial Officer or Auditors Leave the Company
1. When it comes to financial reporting, the watchmen are the CFO and the the corporate auditors. If a CFO leaves the firm you should be on your guard.
2. Same applies to corporate auditors. If a company changes auditors frequently or fires its auditors after some potentially damaging accounting issue has come to light, watch out.
The Bills Aren't being Paid
1. Wall St. loves growth, and companies go to great lengths to keep their top line increasing as rapidly as possible.
2. One of the sneakier to pump growth rate is to loosen customer's credit terms, which induces them to buy more products and services.
3. Companies can also ship out more products than their customers ask for - known as "stuffing the channel" - but this is less common.
4. The loose credit terms are probably attracting financially shakier customers - the pumped-up growth rate will eventually come back to bite the company in the form of nasty write-down or charge against earnings
5. Track how fast A/R are increasing relative to sales - the two should roughly track each other. As a general rule, it's simply not possible for A/R to increase faster than sales for a long time - the company is paying out more money than it's taking in
6. Watch "allowance for doubtful accounts" which is essentially the company's estimate of how much money it wont be able to collect from deadbeat customers. If this 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 their bills.
Changes in Credit Terms and Accounts Receivable
1.Check the company's 10-Q filing for any mentions of changes in credit terms for customers, as well any explanation by management as to why A/R has jumped.
Seven Other Pitfalls to Watch out For
Gains from Investments
Investment income should be reported below "operating income" line on the income statement. The problem arises when companies try to boost their operating results - in other words, the performance of their core business - by shoehorning investment income into other parts of their financial statements
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.
If the firm you're analyzing is using investment gains or asset sales to boost operating income or reduce expenses, you know you're dealing with a company that might be less than forthcoming in other areas as well.
Pension Pitfalls
To see whether the company has an over or underfunded pension plan, go to the footnotes of 10-k filing and look for note labeled "pension and other post retirement benefits"
Pension Padding
Flowing gains from an over funded pension plan through the income statement is perfectly legal practice that pumped earnings (example at GE).
However, this pension-related income is a strange kind of profit, it's not available to pay out to shareholders - it belongs to the pension plan.
Vanishing Cash Flow
Cant count on cash flow generated by employees exercising options. When an employee exercises their stock options, the amount of cash taxes that their employer pays declines.
As long as the firm's stock keep going up and it keeps giving out options, this process continues. More options are exercised, tax deductions are taken and the firm saves cash by lowering its tax bill.
If you're 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.
Overstuffed Warehouses
When inventories rise faster than sales, there's likely to be trouble on the horizon
Change Is Bad
Another way firms can make themselves look better is by changing any one of a number of assumptions in their financial statements. As a very general rule, look skeptically on any optional change.
Check changes to firm's depreciation expense. Longer the depreciation period, the smaller the annual hit to earnings.
Firms can also change their allowance for doubtful accounts. If the allowance for doubtful accounts 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 unlikely. If the allowance actually declines as accounts receivable rise, the company is stretching the truth even further.
To Expense or Not to Expense
Companies can also fiddle with their costs by capitalizing them.
Accrual accounting - benefits have to be matched with expenses. Short term benefit expense, long-term benefit capitalize.
Anytime you see expenses being capitalized, ask some hard questions about how long that "asset" will generate an economic benefit. Looking at the useful life assumption will generally do the trick - a building might be useful for 40 years, but a piece of office furniture or a chunk of software won't.
Investor's Checklist - Avoiding Financial Fakery
1. The simplest way to detect aggressive accounting is to compare the trend of of net income with the trend in cash flow from operations. If net income is growing quickly while cash flow is flat or declining, there's a good chance of trouble lurking
2. Companies that make numerous acquisitions or take many one-time charges are more likely to have aggressive accounting. Be wary if a firm's chief financial officer leaves or if the firm changes auditors
3. Watch the trend of account receivables relative to sales. If accounts receivable is growing much faster than sales, the company may from be having trouble cash from its customers.
4. Pension income and gains from investments can boost reported net income, but dont confuse them with solid results from the company's core operations.