This article provides a basic checklist for those who are interested in financial analysis, a resource they can use to verify the authenticity of the accounts of the companies they assess - in particular when the latter are listed on markets that are a little more exotic than usual.
This non-exhaustive list features some of the usual suspects, common denominators in many fraud and embezzlement cases used by unscrupulous management to fool their investors.
1. Traceability of profits: Are we able to find the companys profits as shown on the income statements on the balance sheet? In other words, once the dividends and the share buybacks have been subtracted, has the equity evolved in a way the accumulated profits would suggest?
2. Conversion of the net result in cash: Can we clearly reconcile the net result with the actual cash profit - or free cash flow in analyst jargon - with the help of the cash flow statements? Roughly speaking this means the operating cash flow minus the investments in working capital and fixed assets.
3. Quality of the turnover: Does the company have a well-identified and diversified client base, or does it depend on one or several big accounts?
4. Suspicious growth: Does the growth of the company exceed that of its industry or the market average? If so, there are two options: either the company is doing something remarkable, or its performance is fictional.
5. Margin profile: If the companys margins exceed those of its peers, the assessed enterprise is either doing something remarkable, for example in terms of cost control or the development of its brand, or its performance is - once again - fictional.
6. The growth in operating assets is in line with that of the turnover: Is the growth of the assets that are linked to the production and the need for working capital proportional to the increase of the turnover? If there is a gap that is too big it either means that the company operates with a high operating leverage, or that something is off - because sales dont just miraculously happen: you have to mobilize assets to make them happen.
7. An unusual increase of deferred income: This accounting mechanism occurs when the client has paid for a good or service that the company hasnt delivered in full yet: this is perfectly legitimate in certain business activities (for example in online subscriptions), but much less so in other cases - this is a matter of good judgment though.
8. Convoluted billings between subsidiaries: Sometimes different subsidiaries from the same company invoice large amounts between them in complete opacity; in this case, you have to look for the number of external sales and, most importantly, have a good understanding of the impact these internal invoices have on the consolidated result.
9. Recurring exceptional gains: Following their operational results, companies tend to report so-called exceptional gains. Generally, the latter come from asset sales made at a price that exceeds the amortized value; when these exceptional gains become more and more regular - and by extension less and less exceptional - this usually means that the profit from the companys ordinary activities needs to be compensated.
10. Unusual growth of receivables in proportion to the turnover: This signifies that an increasing part of the sales is made on credit and that there is no cash being received in return for a delivered good or service; the warning sign is even stronger when the length of the credits granted to clients is constantly extended.
11. An inventory turnover thats slowing down: If the inventory turnover keeps slowing down while the turnover increases this means - at least in theory - that the stocks are piling up instead of being monetized. For small industrial companies or retailers, this is a first warning sign of bankruptcy. It also is a common denominator in numerous fraud cases among Chinese companies listed in Singapore and Hong Kong.
12. Aggressive accounting: The liberties that some managements take - with the complicity of their auditors - have no limits other than their own creativity; research and development expenses that are unfairly capitalized, overpaid assets that are thus overvalued on the balance sheet, profits issued from acquisitions at a price that supposedly is lower than the accounting value of the acquired companies (bargains), too hastily recognized revenue, etc.
13. Excessive management compensation: This signal is particularly suspicious when the performance of the company turns out to be disappointing.
14. Third party interference: It happens - especially in Asia - that certain third-party entities held by the management invoice the company, for example, to provide consulting services or commodity inventories; whats worse, these invoices sometimes exceed the commonly observed market price by a lot. The listed companies that use these mechanisms are in reality vehicles that are designed to transfer money from the shareholders pockets to those of the company directors.
15. Serial resignations of key staff: For example the resignation of the financial directors - generally well placed to know the reality of the companys cash flows - or the administrative members of the Audit Committee.
16. Sale of the shares held by the management: If there is a dichotomy between a management that multiplies triumphant announcements on the one hand but at the same time sells the shares it holds, the former is without a doubt less honest than they appear