Sunday, August 29, 2010

Watching out for Red Flags

Accounting is not a black-and-white process. There are dozens of techniques that are legal and aboveboard, which have the effect of moving numbers around. This may fool the casual observer into thinking that all is well and the company has posted true operational improvements which in reality it is not.

In general, when you are combing through the annual or quarterly reports,watch out for the following:-

1) Declining cash flow. If you continuously see cash from operations decline even as net income trends upward, watch out.

2) Be wary of firms taking frequent one-time charges and write-downs. When a firm take a big restructuring charge, it is essentially trying to improve future results by pulling future expense into the present. DBS recently took a $1 billion goodwill charge, so I am watching this closely as the shareholders are paying for management overpaying for Dao Heng Bank. In addition, try to be careful when Goodwill and intangibles form a large percentage of the firm's net assets.

3) Serial Acquisitions where financials have to be restated and rejiggered until it is difficult to get the true picture of what is going on.

4) CFO leaving the company when accounting issues arise

5) Track how fast A/R are increasing relative to sales. If A/R is increasing by 25% when sales is only increasing by 15%, imply that the firm is booking sales faster than it is collecting cash from its customers. Try to understand it there are any changes to credit terms. A lot of US software in the past "forces" the sales to book any order possible before the quarter closes. Typically some of these will turn out to be "lemons" later on.

6) Gain from investment. An honest company will break this out from sales and report them below "operating income"  line in the income statement. That means the firm is not trying to boost operating results of its core business.

7) Overstaff inventory. When inventory start to rise faster than sales, there might be trouble on the horizon. Try to understand what this rise of inventory is really for. Also, valuation of inventory should always be taken with a grain of salt. For example, for an apparel company, holding a large inventory of last year fashion is surely a sign of trouble.

8) Changing assumptions in the financial statement. Examples are changes in the rules on how depreciation and allowance for doubtful accounts are relaxed.

9) Watch out for how cost are expense or capitalize. I take the case of StarHub. StarHub last two quarter performance is no good. One of the major factor that the management clarify is that they are expensing all their investment in smartphones rather that capitalizing them over the lifetime of the contracts. I think, if this is true, this will be very conseravtive accounting policy which I like ( I believe M1 capitalized the subsidies over the lifetime of the contract, so their performance look better at this stage). Hence, I continue to hold on to my StartHub shares.

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