Portfolio manager Cale Smith on investing, Spoke Funds®, and Islamorada in the Florida Keys.

Q. How can I tell if a company is playing games with its financial statements?

A. You may be the kind of person who likes to dabble in stocks. Perhaps you buy a few shares without doing research just because it gives you a thrill. Or maybe you have a small amount to invest and can’t see the point of putting in 40 hours of research to buy $50 worth of shares.

While I don’t want to discourage anyone from investing in stocks, one of the prerequisites should be that you understand how to read a company’s financial statements. If you don’t, that’s a pretty good sign you need some help when investing. If you can read the financials, there are a handful of things you can check fairly quickly that will help identify certain red flags. Below are seven of them. They are not fool-proof ways to spot fraud by any means, but they can be useful in abbreviated reviews.

1. A company’s earnings should be consistent with its operating cash flow. The two won’t be equal but they should move in the same direction and to a similar degree. Watch out if earnings grow much faster than cash flow for an extended period of time.

2. Be skeptical if current assets other than cash are growing. Keep a close eye on increases in inventories and/or accounts receivable compared to sales.

3. Make sure you understand the rationale behind any impairments or write-offs that are particularly large or recurring.

4. Any accounting policy changes should be explained simply and in a straightforward manner.

5. Depreciation and amortization practices should be consistent among competitors. Deferring these expenses over longer than usual periods of time is one way to artificially inflate profits.

6. Watch for dramatic changes in reserves against bad debt. This can signal deterioration in the quality of current assets.

7. Understand how the company makes money. If you can’t explain this to a five-year-old, it may be a fairly complicated business – and that could mean there is more room for management to play games with the financial statements.

My column in today’s Keys Weekly.

Q. What should I know about a company’s cash flows?

A. The third financial statement that stock investors should become familiar with is the statement of cash flows. Inflows and outflows of cash are the heartbeat of any business, and investors, like company managers and lenders, should examine them closely.

The statement of cash flows is critical because an income statement does not give a complete picture of the company’s most important resource – cash. That is because of differences in timing between accounting transactions and related cash collections or payments. For instance, a company might ship a product and record revenue in March, but not receive a cash payment for it until May. Because of various “noncash” items, income statements don’t tell the whole story.

The statement of cash flows tracks cash across three areas of the business – operations, investing and financing. The most important section to focus on is “cash flow from operations,” which tells you what cash is provided by normal business operations and how much cash is used by the business. Consistently positive cash flow from operations is a sign of a healthy business. Negative operating cash flow, however, means a business is bleeding cash and will eventually need to either borrow money or sell shares simply to stay afloat. Neither are a good sign.

In contrast, a negative number in the “cash from investing activities” section is fairly common and for most growing companies, it is generally okay. Growing companies need to invest more in physical equipment to sustain their growth. The figures in the “cash from financing activities” section usually oscillate between negative and positive. Consistent cash flows from financing activities, however, indicate the company is depending excessively on the stock and bond markets to run its business.

At this point, let’s step back a bit. As you can probably tell by now, there are plenty of ways companies can play games with their own financial statements. The statement of cash flows is one place to catch them. Next week I’ll give you some other places to quickly check for accounting shenanigans prior to investing.

My column today in the media juggernaut that is the Keys Weekly.

Q. What do I need to know about a company’s income statement before I invest?

A. In short – as much as you can stand. A balance sheet contains items that usually don’t merit spending hours on. However, an income statement, also called a profit and loss statement or “P&L”, is a different story. You should try to learn everything you can about a company’s income statement to really understand how the company makes money.

You’ll recall that a balance sheet is a snapshot in time, telling us how well a company is managing its resources. The income statement, together with the cash flow statement I’ll discuss next week, forms more of a moving picture that tells us how well a business is managing its operations.

The term “earnings” on the income statement is synonymous with profit, and it’s hard to argue that you should invest in a business for any other reason than because of attractive, growing profits. Because of that, earnings are the most widely scrutinized financial metric that companies report. Management has some latitude when applying accounting principles in the income statement, so assessing the quality of those earnings is an important ability for a stock investor to learn.

There are no shortcuts to learning how to analyze an income statement. It can take some time, but I’ll soon publish a list of recommended books to help you start to learn as quickly as possible. It’s important to keep the big picture in mind, though, as per this quote from Warren Buffett, “Your goal as an investor should simply be to purchase, at a rational price, a part interest in an easily-understandable business whose earnings are virtually certain to be materially higher five, ten and twenty years from now.”

If I had two tips for investors regarding income statements, the first is to be wary of investing in companies with pension plans. Pension accounting can be the greatest form of earnings manipulation known to man. The second tip would be, “Profit is an opinion, but cash is a fact.” Next week I’ll talk more about cash flows.