As an investor in individual company shares, it is important to understand how the rules of accounting work. I have mentioned this many times on this site. The accountancy quirk about conglomerate balance sheets is one such instance. Understanding a company’s account will give you a true picture of the company’s quality. It will also give you an indication of the management as it is important to assess whether management is trying to hide bad results in the accounts; financial engineering is all too common these days.
Investment bank Liberum recently identified 13 accounting red flags in order to spot companies which might have problems now or in the future. Spotting red flags could help you identify companies which are heading towards a profit warning, and enable to get out before disaster hits the value of your investment.
- Exceptionals: Constantly adjusting earnings to account for ‘one off’ items. Sometimes a business faces genuine unique one-off items which would otherwise obscure its underlying performance. However, if earnings are consistently being adjusted it implies management are trying to flatter performance.
- Doubtful debtors: Doubtful debtors are parties which owe money to a company and are likely to default on their loans. You should look for signs the level of doubtful debtors has increased markedly; there shouldn’t be any material difference in this figure from one year to the next.
- Revenue recognition: Receivables. An increase in the amount of receivable days (calculated by dividing average receivables by revenue and multiplying by 365) implies parties which owe money to a company are taking longer to settle their bills. Or it could be that the company is recognising revenue very early to boost their results in the near-term.
- Revenue recognition: Longterm receivables and contract accounting. This involves booking revenue from business where the company will not see the cash or at least one year.
- Revenue recognition: Deferred revenue Cash received for business not yet carried out should be classed as deferred revenue but this is not always the case. You should look for material reductions in deferred revenue.
- Working capital: Inventory Increases in ‘inventory’ could imply a company has mismanaged its stock and may have to write off its value if business slumps.
- Working capital: Payables Screen for increases in ‘payables’ or how long it takes a company to pay its bills.
- Debt for dividends: Cash dividend cover Look for companies which cannot cover their dividend with internally generated funds.
- Capex: Free cash flow flattery/ ageing asset portfolio. Identify firms which have cut spending to boost cash flow in the near term which could leave them with ageing and/or outdated equipment.
- Bankruptcy and manipulation models: Use the Beneish M-score and Altman Z-score academic models to identify stocks which are manipulating earnings or are at risk of going bust.
- Operating leases: Accounting policy changes. An operating lease is a contract which allows for a company’s use of an asset. For example, for a retailer this could be a shop. New rules as of 2019 require these to be recognised along with other liabilities. This could have an impact on bank lending facilities which include stipulations on the proportion of earnings to debt, known as debt covenants.
- Governance: Board independence. Look at how long senior management have been in place. Check if the chairman and chief executive role is combined (generally deemed a bad thing) and the percentage of the board which are non executives.
- Size of CEO remuneration: Check not just how much a chief executive is paid but also if they are over paid in such a way which would incentivise them to flatter earnings.