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.
What is Due Diligence and How to Do It?
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:
- Analyze the company’s market capitalization – This can help you understand the volatility of the stock price and the size of its customer base. So, a large-cap company will have less volatility in the stock price since it will have a stable revenue stream and a large & diverse customer base.
- Look at trends in profits and revenues – When you look at the income statement of a company, you can check its revenues and profits. While looking at the current quarter’s profits is important, it is necessary to look at the trends over multiple quarters or years. This will give you a perspective on the company’s performance.
- Competitive analysis – Compare the profits and revenues of the company with 2/3 close competitors. Also, assess how the industry is doing.
- Financial ratios – Look at the Profit to Earnings ratio (P/E), Price to Book ratio (P/B), Debt to Equity ratio (D/E), etc.
- Management Analysis – Analyzing the management of the company is important since the growth of the company is determined by the decisions made by the management team.
- Balance Sheet – Analyze the company’s balance sheet and to understand the company’s assets and liabilities along with the available cash.
- History of the stock price – Look at the long-term and short-term trends in stock price and compare them with the profits generated by the company. This can help you choose a stock based on your risk tolerance.
- Stock dilution – Is the company issuing shares frequently to raise funds? If you observe this trend, then you must consider the possibility of stock dilution.
- Assess risks – Look at all the risks associated with the investment – capital market risks, liquidity risks, regulatory risks, etc.
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 of investing 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 to 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 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.
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.
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