Six recurring signs
- Profit without cashOperating cash flow far below net profit, year after year. (Cash flow statement)
- Receivables outgrowing salesSales are booked but the cash lags behind. (Balance sheet and income statement)
- Inventory piling upInventory grows faster than sales, which can mean goods are not selling. (Balance sheet)
- Dividends above free cash flow while borrowing risesThe company pays out more than its free cash flow while its borrowings rise at the same time. Check the sources of funding. (Cash flow statement and notes)
- Profit leaning on one-offsMuch of the profit comes from asset sales or revaluations, not operations. (Income statement and notes)
- Auditor's report and accounting policiesA qualified opinion, an emphasis-of-matter paragraph, or frequent changes in accounting policies. (Auditor's report and notes)
Example: compare growth rates
ExampleAn invented company grew revenue by only 10%. In the same year receivables rose 60%, inventory 45% and borrowings 80%. Each figure alone may have an explanation, but when these items all grow far faster than sales, it tells you to open the notes and find the reason before trusting the profit figure.
Change versus last year
Revenue+10%
Receivables+60%
Inventory+45%
Borrowings+80%
How to treat a sign
Start with the notes, which usually explain large changes. Then read the auditor's report and check the same item over several years. One sign in one year can be perfectly normal. Signs that repeat, or arrive together, deserve a longer look.
Watch outNone of these signs proves an error or manipulation. A fast-growing company may see inventory and receivables rise naturally, and one building a plant may borrow more. A sign tells you to ask; the answer comes from the statements and notes themselves.
Each sign has its own lesson in this path, such as earnings quality and debt and leverage.
Try it on real statements
Open a company's statements for two years in the disclosure archive, compute the growth in revenue, receivables, inventory and borrowings, and compare them.
Check yourself
1. Sales rose 5% and receivables 50%. What do you do?
A sign is a question, and the notes are the first place to find the answer.
2. Dividends 100 million, free cash flow 40 million, borrowings up 60 million. What does that suggest?
There is a 60 million gap that coincided with a 60 million rise in borrowings; check the funding sources in the cash flow statement and the notes. The match alone does not prove the loan was taken to pay the dividend.
Summary
- Common signs: profit without cash, receivables and inventory outgrowing sales, dividends above free cash flow while borrowing rises.
- Compare items' growth with sales growth, over several years.
- A sign is a question, not an accusation; the answer lies in the notes and the auditor's report.