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Is it possible to foresee an accounting disaster? - Views on News from Equitymaster
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  • Mar 2, 2012

    Is it possible to foresee an accounting disaster?

    Quite a few companies have come into the limelight for all the wrong reasons. Bailout candidates, accounting frauds, the list is quite long. Investors who have invested in such companies have lost a significant amount of their hard earned money by holding on to such companies. The question in most of their minds is could we have foreseen this earlier? The answer to this question is yes. Though it is not always possible to foresee a financial disaster, but there are some warning signs or red flags that investors could look out for that would indicate imminent danger.

    In the next few articles, we will not only discuss what these warning signs are but also discuss the management's motivations behind manipulating their numbers. We would also go through some examples of companies where warning bells had started to ring even before the bad news came out.

    Let us first start with how to spot red flags in as company's financial statements. Or some warning signs that could indicate future trouble:

    1. Cash flows do not match net income: The business of a company is to generate both sales and profits. But at the same time, these profits should ideally be generating cash for the company as well. A good place to spot a red flag is to compare the company's cash flows to its earnings. If earnings have been increasing but cash from operations has been declining or turning negative, then it means that the company is just reporting higher income. But in reality its operations are actually burning cash.

      A simple measure to check this is to look at the cash flow index. This is the operating cash flow (cash from operations) divided by net profits. If this ratio consistently remains well below 1, then it could be an indicator of potential problems.

    2. Stellar growth rates: Fundamental analysis always advocates that an investor should look for a company that is already a leader or have a strong hold in its niche or the area of the industry it operates in. Such companies would naturally be expected to have revenues and earnings that are higher than that of their peers. But what an investor needs to pay attention to is the quality of these revenues. Are the revenues higher because of the premium that the company's products/services command or are they just numbers? For this, the investor should look at the growth in the company's sundry debtors numbers. If the growth in receivables outpaces that in sales, then there is a huge probability that the revenue numbers are just that. Numbers. Not reality.

      The ratios that the investor needs to watch out for over here is the receivables days or (total debtors divided by net sales) multiplied by 365. Looking at this ratio in conjunction with receivables as a percentage of total sales, would give a clear picture on whether sales are real or nonexistent.

    3. Non-recurring items: None recurring items are the one- time items that are not expected to occur again. Examples of these are gains made from the sale of a subsidiary. Or losses due to a natural disaster. However, the important thing to note here is that these by definition are not supposed to be a recurring item. A clear red flag is when non-recurring revenues or expenses are consistently contributing more toward the company's top and/or bottom line.

      The investor has to be careful when he comes across non-recurring or extraordinary items in the company's financial statements. It is important to adjust revenues as well as earnings for such items. So if a company's reported earnings are growing consistently, but its adjusted earnings (adjusted for the non-recurring/extraordinary) items have been declining, then something is wrong. The company maybe using innovative methods to project results better than what they actually are.

    4. Excessive debt: Debt in itself is not such a bad thing. But excessive debt is a termite that eventually hollows out the entire company. Companies burdened with too much debt lack the financial flexibility to respond to crisis. They are particularly vulnerable to economic downturns. And the problem worsens when the debt is taken on to run the day to day operations of the company and not really for expansion. This is an indicator that maybe the company is not generating cash and cannot sustain itself without debt. The pack of cards collapse when the time comes for the repayment of the debt. Because when this happens, the company has to look for funding sources. And in the worst case scenario, throw in the towel and pack up operations.

      The indicators for excessive debt are actually two. The first is referred to as the debt-to-equity ratio (DE ratio). This is the total debt divided by the total shareholder's equity. Ideally the DE ratio should be 1 or below but it is best to compare it with the general industry level. Some industries are more capital intensive than the others and hence need higher levels of debt. The second ratio is the interest coverage ratio which is the operating income (EBIT) divided by its interest expense. The ratio is used to determine how comfortably a company is placed in terms of payment of interest on outstanding debt

    5. Subsidiary saga: The best way a company can misguide an investor is by creating plenty of subsidiaries and 'related parties'. Sometimes it is necessary for a company to form a subsidiary when a company is expanding operations into a particular country or when it is diversifying operations. But having too many of them when it is not known as to what these subsidiaries do? That is a bad idea. Why? Because the company can skillfully transfer income and profits in and out of these companies and completely mislead its investors. A case in point is the erstwhile Enron that had 2,500 offshore accounts, 850 special purpose entities and hundreds of partnerships that it never bothered to disclose.

      The best thing for an investor to do is to stay away from such companies. But if they still want to go ahead with investing in such companies, then it is good to go through the footnotes and related party transactions to spot the red flags.

    6. Strange account names: Ask any accountant and he will tell you the generally used account names. As an investor you would come across some companies that have strange account names like 'deferred subscriber acquisition costs' that are forming the largest part of the company's asset base. Though in themselves such accounts may not be fictitious but if they form a very large part of the asset base, then this could be another warning sign.

    7. Too many acquisitions: Acquisition is a route taken by many companies to expand their operations inorganically. It is an effective way to expand the company's footprint. But at times this could lead to disasters. Drunk with the power of excess cash, companies at times end up making ridiculously expensive and very often unrelated business acquisitions. Then they try to justify these by stating that these are in line with the company's bigger strategy. Bottom line if the acquisition does not add value to the company's sales and profits, then it is a value destroyer. Such companies would eventually run into trouble sooner or later.

      The investor should go through the management communication related to the acquisition. That would have essential information pertaining to the company's plans with the target company, its contribution to the financials, price paid, etc. If things sound a bit too hunky dory, then it is a red flag. Stories of future growth and stellar prospects, all fall flat unless the company delivers on sales and profits.

    8. Constant re-classification of accounts: Usually accounts are reclassified retrospectively if there is a change in accounting standards or accounting policies. However, if the company keeps reclassifying its accounts a bit too often, then it could be using this as a means of overstating revenues and/or expenses. If such changes lead to a huge jump in profits, then it should raise a red flag. Usually the companies report changes due to reclassification or restatement in their footnotes to accounts.

    9. Too good to be true: Companies that consistently meet earnings estimates & projects high growth rates over a long period of time, should be treated as a red flag. Such companies are under the greatest pressure to meet expectations and therefore have the biggest incentive to falsify numbers.

    10. Pay attention to the auditors: Last but not the least pay attention to what the auditors have to say. Usually the auditors write a remark in their report if the company is doing something fishy. This in itself should raise the red flag.

    11. Deteriorating product or service quality: Quality is perhaps one of the most subjective things. But consistently declining quality of product or service could be an indicator that the company does not have the money to maintain its quality status. Hence a potential red flag.
    These are just some of the ways in which an investor can spot red flags before they happen. An important thing to note here though is that anything in isolation does not really suggest a red flag. It is the trend that matters. So look at the trends and we hope that this helps you to identify potential disasters.



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