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.
Q. What kind of information should I be looking at on a company’s balance sheet?
A. You’re in luck, dear readers. There is simply no way to teach balance sheet analysis in a 350-word column. The official definition of “current liabilities” itself is 200 words long. My hunch is that many of you would rather get a hot poker in the eye, anyway.
Fortunately, there are many resources out there for the motivated investor – the best being Graham and Dodd’s Security Analysis. I’ll cover just a few highlights here.
And rest easy, math-phobes. There is only one equation you need to remember: Assets = liabilities + shareholders’ equity. Or, the stuff on the left must equal the stuff on the right, so the two sides “balance.” Hey, nobody hires accountants for their creativity.
The balance sheets of companies in the finance, utility and railroad industries are a bit specialized. Most retailers and manufacturers, however, use fairly consistent terminology and formatting. At a high level, then, on the left side are assets, or what the company owns; on the upper right side are liabilities, or what the company owes; and on the lower right side is shareholders’ equity, or what has been invested in the company. Liabilities are listed above equity on the balance sheet to remind you that the debtors have a higher claim on assets than stockholders. So don’t get too cocky. Also remember that a balance sheet is a snapshot at a given point in time, not a record of changes.
In his book, Ben Graham summarized a key point in balance sheet analysis: “The liabilities are real, but the value of assets must be questioned.” Except for cash, the value of assets is often up to management’s accounting philosophies. The value of liabilities is not subjective, however, and it’s usually not worth the effort to scrutinize shareholders’ equity. So to analyze balance sheets well, focus on assets.
While the balance sheet can be a strong indicator of the health of a business, it’s also backward-looking. It doesn’t tell much about future income. We’ll get to that next.
My article in today’s Keys Weekly:
Q. What does it mean to “short” a stock?
A. Buying stock in anticipation of it going up, the way most people traditionally think about investing, is considered “going long.” Shorting is a way to profit from the decline in a stock’s price. Here’s an example.
For several years, Captain Jack noticed an increasing number of passengers wearing brightly-colored, odd-looking shoes called Gatorz. A few weeks ago, Jack noticed a sudden decline in the number of tourists wearing the shoes. He thinks the fad has finally passed, and as a result he expects the company’s stock price to fall.
Jack calls his brokerage and tells them he wants to short ten shares of Gatorz (ticker: CLOG). The brokerage then “borrows” those ten shares, typically from another investor who owns them, and immediately sells them into the market at the current price, in this case, $20. The proceeds from the sale, totaling $200, are then deposited as cash in Jack’s brokerage account.
A week later, Gatorz reports its quarterly earnings and, sure enough, sales of its footwear have completely tanked. The stock falls from $20 to $5. Jack “covers” his short by buying shares on the open market to replace the ones he borrowed from his brokerage. Because Jack shorted CLOG at $20 and covered when it fell to $5, he made $15 per share, or $150 total.
Shorting is similar to asking your brokerage for a loan – only the loan is made in stock, not dollars. When done as part of a traditional long portfolio, shorting can help you profit from both rising and falling stocks. Shorting also comes with some risks, however.
Because a stock’s price can theoretically rise forever, your losses from shorting could be unlimited. Being short also means you’re fighting the general long-term trend of the market, not to mention the effort of a company’s management team. In addition, if the stock you shorted pays dividends, you’ll be required to pay them. For those reasons, shorting is usually better left for professional investors.
Next week I’ll discuss naked shorting. You know you can’t wait.
$TNDM This is the comp the mkt worries about? Peerless can't seem to raise VC $, more discounts & use credit lines...? http://bit.ly/bQo0Fd 2 days ago
