Over my 15 years of meeting with company management teams, one thing became abundantly clear.
The chief executive officer (CEO) was the company's head cheerleader, while the company's chief financial officer (CFO) more reliably counted upon to give the unvarnished truth.
But behind the scenes, these two executives can conspire to put the best spin on a company’s financial statements. Even in the context of law-abiding financial reporting, there is so much wiggle room in how accounting items are treated that investors may be missing some important details if they fail to really dig into the numbers.
You should hold off buying a stock -- no matter how appealing -- until you've spent some time with the financial statements. It's also very important to listen to a company's conference calls, which are usually archived on their website. In the Q&A section of the conference call, you can eavesdrop as institutional investors try to spot any red flags on the financial statements.
To get you started, we've put together a handy list of bright red flags that should clue you in as to whether or not mischief is afoot. Here are the top four places bad news can hide.
1. Increase in Accounts Receivable.
This is probably the most common area where investors get burned.
Companies need to make a clear assessment of which customers are having trouble paying bills. If a customer is late in paying an invoice, that could be a sign that the bill won't get paid at all.
So companies are supposed to report how much money they are owed -- 'Net of Doubtful Accounts.' That means they should conservatively assume that late bills may be uncollectible. So whenever you see accounts receivables rise -- especially when calculated as a percentage of sales -- you should look deeper.
Companies may look to forestall the inevitable by citing a more aggressive accounts receivable figure. On the conference call, management should clearly address any questions that might arise regarding receivables.
2. Falling Gross Margins.
Companies often sell products and services that carry a wide range of profit margins. For example, a tech company that sells a bundle of hardware and software will always make more profits on the software part of the contract. So when gross margins drop, companies will often chalk it up to 'a change in the sales mix.'
But investors have no way of knowing if that's really the case, or if the company is simply hiding the fact that it has to cut prices to win business. And that's never a good thing. So listen in on the conference call to see whether there is a good explanation about that changing sales mix, and if it is simply a short-term aberration. If not, the company's gross margins may be in a secular decline and its best days may be behind it.
3. One-Time Charges.
If a company experiences short-term events such as severance pay and wind-down costs for a plant closure, then it can exclude those costs from its quarterly results. But you should be concerned when one-time charges pop up every quarter. These are not 'one-time events' -- they are likely the normal cost of doing business.
In the last five years, Hewlett-Packard (NYSE: HPQ) has taken these charges each year. In 2009, the company had $640 million in restructuring charges and another $889 million in 'unusual expenses.' Analysts generally ignore these figures when valuing a company. But how do we know if the company isn't simply burying normal expenses into these charges? You can find some explanation of the charges in the footnotes, but details are often left intentionally vague. You should steer clear of any company that repeatedly comes up with these vague and opaque charges.
4. Rising Inventories.
When a company is sitting on a rising pile of unsold goods, management will often suggest that production has ramped up to meet expected higher demand. Or they'll note that production took place late in the quarter, too late to ship to customers and recognize a sale in the quarter.
Those excuses are perfectly fine for one quarter. But if they persist for two or more quarters, then management could be hiding the fact that demand is not meeting forecasts. As noted earlier, CEOs are eternally optimistic, and they hate to admit that growth is slowing. Yet if inventories are rising, then they might need to slash prices to move unsold goods. This is especially true in the field of retail.
Your best investments will involve companies that you've been able to closely track for a while. By looking at these items, quarter after quarter, you'll see if any troubling trends arrive.
My favorite companies are those that tend to err on the side of conservatism every time an accounting question arises. For example, a company might move any late-paying customer's bills into the 'doubtful accounts' category, even though some of those customers will eventually pay up. Or a company may take seemingly one-times costs and roll them into normal operating expenses, instead of resorting to the 'one-time charge' gimmick. That means they are willingly looking to dampen short-term earnings for the sake of long-term credibility.
Over the long haul, the management teams with the highest credibility are rewarded with a solid set of dependable investors.
