Analyzing financial statements is a key step in fundamental analysis. There are many ratios and tricks to ensure that you get the complete picture of a company’s financials before investing in its shares.
However, with companies trying to highlight certain aspects and keep certain others hidden, it takes an accounting brain and an in-depth analysis to get to the bottom of many aspects.
Since that is not possible for every investment decision, we have collated some obvious signs that indicate a potential problem with a company’s financial statements – The Red Flags.
Financial Statement Red Flags help investors get a quick indication of some problem that the company has or might face in the near future. Once these flags are highlighted, the investor can decide if he wants to analyze further or decide to stay away from the stock.
Before we look at some common red flags, we would like to mention that there is no fixed method of identifying red flags. Based on how you are researching the company and the way you examine historical and current data will define how you identify potential problems. Also, you must exercise due diligence before investing in a stock.
When you analyze the financials of a company, it is important to confirm the facts under consideration. The process of reviewing the financial records to confirm this is called due diligence. Here are some important steps to help you exercise due diligence while investing in stocks:
Let’s begin with looking at some obvious and easily recognizable red flags that should make you stop and rethink your decision of investing in the company.
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:
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.
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.
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.
You will be able to see the impact of these changes on the financial reporting of the company.
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:
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.
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.
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.
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.
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.