Accounting Red Flags the Easy Way
Use cash flow to detect creative
news when one of your holdings reduces its earnings forecasts, or
actually reports earnings below expectations. Such events usually
trigger a substantial share price drop.
some investors go to great lengths to detect “red flags” warning of
future earnings shortfalls. But that kind of analysis entails taking
calculator in hand and digging into financial statements. Many investors
don’t have the time it takes to perform a detailed financial statement
analysis. Here’s the good news: there is an easier way by comparing cash
flow to net income.
Let me define
the problem before getting to the details.
Firms often experience fast growth during their early years. During
these heady times, everybody involved assumes that the strong growth
will continue indefinitely and the stock price invariably reflects those
expectations. But eventually the firm begins to saturate its market and
the growth rate falters.
growth slowdown will sink the share price, some managers resort to
creative measures to mask the falloff. For instance, they may encourage
customers to order unneeded products by offering longer payment terms
(e.g. one-year instead of the usual 60 days), a practice known as
“channel stuffing.” Another way to stimulate demand is to cut
prices. Of course reducing prices without corresponding cost savings
decreases profit margins and hence earnings. But that result can be
masked by inflating inventory dollar values, which increases margins.
jinks leave tracks. Channel stuffing increases accounts receivable
(monies owed by customers) levels since customers are taking longer to
pay. Profit margin manipulation abnormally increases inventory values.
Savvy investors detect these shenanigans by watching for unusual
increases in accounts receivable or inventory levels. But there is an
explain, but you first need to know a couple of definitions.
accounting hanky panky that I described earlier increases earnings, but
not cash flow. For example, extended terms means that the company
isn’t receiving its usual payments from customers.
Net Income to Cash Flow
Recent academic research found that you could detect these accounting
tricks by simply comparing net income to operating cash flow, instead of
digging into the details. What you’re looking for are instances where
net income increases, but cash flow doesn't. You can find both figures
on the cash flow statement. Here’s how to do it.
quarterly cash flows are volatile, the analysis works best using annual
numbers. Morningstar’s new 10-years financial report is ideally suited
to the task. The report shows condensed versions of a firm’s income
statement, cash flow statement, and balance sheet, in separate columns
for each of its last 10 fiscal years.
camera maker Concord Camera (ticker symbol LENS) to explain the process.
From Morningstar’s home page (www.morningstar.com),
get a price quote, select Financials
(10-years), and then scroll past the income statement to the cash
flow statement. There, net income is the top line, and cash from
operations is four lines down.
wasn’t consistently profitable until its 1998 fiscal year (June 1998)
when it reported earnings of $6 million. Earnings rose to $7.7 million
in 1999 and then shot up to $19.6 million in fiscal 2000. But operating
cash flow told a different story, falling 45 percent in fiscal 2000 from
1999. That was a red flag, since earnings more than doubled, but cash
worked! Earnings turned into losses the next year. Concord filed its
June 2000 annual report on August 30, 2000. You would have had plenty of
time to analyze the report before Concord’s share price peaked near
$40 in mid-October. Earnings shortfalls drove it down to the $5 range a
few months later.
similar examples for outsource manufacturer Jabil
Technologies and software maker Autodesk.
occurrence of rising earnings combined with falling cash flow doesn't
necessarily imply accounting shenanigans. Accounts receivables could
increase because customers don’t have the cash to pay. An unforeseen
sales slowdown could push inventory levels up. However, these events
could also foretell an earnings slowdown.
take my word for it. Morningstar’s report format makes it easy to look
up your own stocks and determine whether the correlation between rising
earnings and falling cash flow signals future earnings declines. You
don’t even need a calculator.