Unfortunately, companies tweak figures in financial reports to look better. They can present unrealistic projections without actually fulfilling them. Hence, investors might be misled by the figures shown in financial statements.
Here are some red flag signals where investors could take a closer look before accepting the bottom line figures presented by the management.
Erratic Cash Flow
Huge volatility in operating cash flow. This signal shows that company might have problem in managing their cash flow regardless of receiving cash or making payment to supplier. Some might face pressure from supplier due to the management creditworthiness and has a shorter payment term. This will lead the company into a death spiral where liquidity issue could drive company into bankruptcy even if the company is recording huge profit.
Changes in Depreciation Method
Depreciation takes up a sizable expense in a company income statement. Some company might change their depreciation method not according to the relevant asset useful lifetime. Companies which requires high asset level to operate may change their asset useful life (Eg: from 8 years into 15 years) to reduce depreciation cost in order to lift up the bottom line.
Huge increase in receivables
The management might adopt a lose credit policy to increase the sales of their products and services. This may show a leap in both revenue and profit but ignoring the risk of not being able to receive payment from their customers. Companies has a tendency to do so at the last quarter of the financial year in order to present a more presentable financial statement but this action will definitely harm the company in long term.
Expenses being capitalized
An expenses added to the fixed asset on a company’s balance sheet. Companies might convert some of their expenses, such as financing cost into property and plant; research and development cost may be added up to the companies’ intangible assets. This has an effect of inflating the company Net Tangible Asset
Inventories pilling up
Products that may be obsolete or out of the market favour may be kept in the company warehouse for a long time. The management should have made an impairment on the product or provide a provision for impairment regarding the obsolete inventory. This is also a sign that the company has faced problems in selling their goods.
It does not mean the company you invest is bad if it falls into either one of the category. Just take a closer look before you think you had found a hidden gem.