Financial Markets Institute of Australia

LESSON 5:  RED FLAGS THAT WILL SAVE YOU

Sometimes the management of a company will use accounting tricks to make their companies look better than they really are. The incentive for this is greatest for companies that are in trouble.

The concepts covered in this lesson are:

  • How to spot some of the most common accounting tricks
  • How certain types of companies use aggressive accounting

1. Check for Red Flags Before You Buy

Management teams often distort the financial image of their companies.

This can range from:

  • Relatively harmless changes in accounting estimates
  • Fraudulent recognition of bogus revenues

You need to learn how to identify companies that are using accounting tricks, as these companies are often ones that are in trouble.

6. Accounts Receivable Rise Faster than Sales

Some companies go to great lengths to keep sales growing. An underhanded way to boost sales growth is to loosen credit terms. This encourages customers to buy more products.

7. Overstuffed Warehouses Spells Trouble

This is not sustainable, as the company is paying out more money (in the form of products) than it’s taking in cash payments.

Inventory turnover can be calculated by dividing a company’s cost of goods sold by its in inventory turnover means that money will be tied up in inventory for shorter periods of time.

Example – Manipulating Depreciation Costs

Companies have some choice in how they depreciate assets.

If a company assumes an asset wears out in 10 years, it subtracts one-tenth of the asset’s value from its earnings each year. If the asset is assumed to last longer, the expense is smaller.

Key Points

  • The financial statements of companies are sometimes managed to create favourable impressions.
  • Check for red flags before you invest to avoid losing money.
  • Are expenses capitalised when they should be included in the P&L? This means that current profits may be overstated.
  • Does the company have an artificially low tax rate that is boosting earnings?
  • A red flag is not a sure sign of trouble, but it is a sure sign that you should be more cautious.
  • There’s no need to invest in a company with red flags when there are so many great companies out there.

Learning Checkpoint

1. What is a red flag?
2. Why should you avoid investing in companies with red flags?
3. ‘Rising net profit is always a good sign, even if operating cash flows
are declining’. True or false? Justify your answer.
4. Why should you be wary of companies that grow by acquisition?
5. What does it mean if accounts receivable grow faster than sales?
6. Explain why rising inventories are a risk for retail companies.
7. How do you calculate inventory turnover?
8. A company changes an accounting rule voluntarily. Under what
circumstances would this be viewed as a red flag?