Warning Signs for Investors: How Companies Can Fool You
What to pay attention to when deciding where to invest
Companies cooking their books, inflating the number of customers, misrepresenting their activities, engaging in fraud… Over decades we have seen so many ways in which businesses in various sectors have attempted and succeeded in deceiving investors about how well they perform and how worthy they are of their investment. All around the world. If you are not vigilant, you might get fooled as well. But if you look closely and diligently, you will usually be able to see some clear warning signs that could alert you to such problems and help you avoid taking losses later when such schemes fall apart.
The content of this post does not constitute financial or investment advice. It is intended for information and education purposes only.
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When market euphoria is high and financial conditions are relatively loose, misallocation of capital can become rampant. In such situations, it becomes ever more important and at the same time, ever more difficult to spot which investments/businesses hide significant risks. Everybody just wants to jump on the bandwagon, deploy capital, and go along for the growth ride, even if they do not really understand what could be happening in the background.
The current system is unsustainable
There are enough striking examples in history of how the presumed to be “forward-looking”, “always right” and “efficient” stock market can get it very, very wrong. In the 80s, ZZZZ Best, a carpet cleaning and restoration company built on forged documents and fraud, managed to go public and reach a market cap of over $200m, only to be exposed as a Ponzi scheme whose project and business activities were essentially non-existent. In the 90s, there was Waste Management Inc. where inappropriate accounting practices had led to significant profit overstatements for several years — keeping investors completely misinformed.
Some of the most famous cases are, of course, WorldCom and Enron. At the height of the Dot-com bubble, WorldCom, one of the largest long-distance telephone companies at the time in the US, had been growing rapidly via acquisitions of other companies. It used accounting shenanigans to overstate its earnings and cash flow until US and EU regulators prevented one of its acquisitions of a much larger company, which cost it its ability to release new reserves into income. When it could no longer hit earnings targets, it started capitalizing network providers’ fees, which conflicted with accounting standards that required that they be expensed instead. The fraud was discovered in 2002 by internal auditors and not long after that the firm filed for bankruptcy.
Enron, the American energy trading giant, used a combination of business changes and off-balance sheet accounting, to create a picture of its financial condition that was very far from reality. It became a huge commodities trading company and had a significant increase in revenues in the second half of the 90s. However, it used shell companies to keep its debts off the books and to show fictitious sales. When the scam unraveled in 2001, it took down not just Enron, but also one of the biggest accounting and auditing firms at the time — Arthur Andersen, whose auditors were directly involved in concealing the fraud and even destroyed key documents for which it was found guilty of obstruction of justice in 2002.
One of the biggest corporate scandals in the last several years came from Germany. Wirecard, a payments processing company, was founded as a Fintech business that had the ambition to disrupt the traditional financial industry. Its share price exploded in the 2010s, reaching a peak in 2018 when it was added to the German benchmark stock index DAX, replacing the 150-year-old Commerzbank. Over the years, Wirecard raised significant amounts of capital and acquired obscure payments companies in Asia, using strange deal structures, while being unable to explain accounting inconsistencies revealed in the media and during financial audits. Later, it was also discovered that profits at the Dubai and Dublin units were fraudulently inflated and that customers listed in documents provided to Earnst and Young did not exist. In 2020, KPMG’s audit could not verify that reported profits or cash balances were even genuine. In June 2020, after the arrest of the former CEO and the investigations of the board for accounting fraud and market manipulation, the company filed for insolvency.
Always look for the red flags
Generally speaking, management has both some flexibility in the selection of accounting policies and their application, as well as incentives to make such choices that show the best possible picture of the financial position and the profitability of the company they manage. Therefore, when looking at financial statements and especially before making an investment, one needs to be on the lookout for certain warning signs coming from those numbers and the disclosures (or lack thereof) that may indicate something fishy may be happening in the background that is not immediately visible from what company management is trying to display.
Below is a non-exhaustive summary list of those red flags that one should always keep in mind before putting money into a company to avoid situations like being the latest person to join Bernie Madoff’s Ponzi scheme or being a Wirecard investor.
1. Too much revenue or revenue growth
Put otherwise, aggressive revenue recognition. Technically, that means that management is trying to inflate the profits it shows to investors by reporting a high amount of revenue or growing that revenue uncharacteristically quickly over time. Unlike smaller private businesses which do not need to care about share price performance and therefore are inclined to show smaller revenue in order to pay lower taxes, public companies and their managers (usually rewarded with equity-linked compensation packages) aim to show bigger income to meet investor and analyst expectations.
What should you look for? Material changes in the business model of the company or a number of atypical business activities may be linked to fictitious sales. But those may not be easy to recognize or identify as such. Some activities or products that the company has promised to develop but has not yet, or when the work on a contract is not yet completed — while already recognizing revenue from their “future sales” — are a definite warning sign. Another way is to compare how competitors operating similar businesses or offering similar products and services recognize their revenues — if their timing differs significantly, this may signal something is not right.
Non-recurring revenues are sometimes booked as part of revenue to give the impression of a high growth of the income streams — which is of course misleading. In such situations, investigating the notes and additional disclosures to the financial statements could help find out more. Another red flag is when net income is growing while operating cash inflows are decreasing or remain unchanged. You can combine this with an analysis of the Days sales outstanding (DSO) ratio — which shows how quickly an entity manages to collect its revenue after the sale. It is calculated by dividing the average accounts receivable outstanding by the revenue, multiplied by the total number of days in a period (generally 365 days). An increase in this ratio could indicate problems with payment collection from customers, problems with the terms the firm is offering to clients or inefficiency in the company’s credit process.
2. Inventories vs. Sales
There are different types of inventories, so it is important to distinguish between them in order to understand the underlying economic situation. If raw materials and manufacturing inputs are accumulating, this might mean that the company is not managing its supply chain, procurement and production processes efficiently, which can result in a reduction in its profit margins over time — and respectively to losses. A build-up of finished products, on the other hand, could point to a drop in customer demand — which could in turn lead to write-offs or price decreases that could eat into the company’s margins.
Inventory turnover is a useful indicator of how those resources are managed by the company. It shows how many times a company has sold and replaced its inventory over a given time horizon. The lower it is compared to historical values or to other similar companies in the industry, the worse job management is doing at managing its inventory — e.g. it could be due to obsolete technology, inefficient processes, market/demand changes, etc.
3. They will not get that money!
Many companies sell their products and services on credit, meaning that they book a receivable amount that they plan to collect, according to the agreement with the customer, on a future date. However in certain economic conditions (like during the Great Recession and the Covid recession), the ability of those customers to repay what they owe the company may become significantly impaired. If clients are expected to default, management has to allocate allowances whose purpose is to reduce those receivables over time and gradually recognize a loss. With the incentives to avoid that, managers can decide to underestimate those allowances, thereby inflating once again earnings and assets. One indicator could be the fact that the company is turning down new business, while delinquent loans grow on the balance sheet and days receivable (measuring the average number of days it takes to collect them) increase compared to historical or industry numbers.
Similarly, other short-term assets might need a correction — such as materials or finished products, that have lost value because, for example, have not been utilized or sold on time. Management may again decide to postpone such write-downs in order to avoid reducing its earnings or showing losses. A possible indication of such activity could be an increase in the days of inventory on hand (i.e., the inverse of the inventory turnover, showing how quickly in days on average inventories move through the firm’s production & sales cycle). If competitors operating in the same business and suffering from similar changes in market demand are writing down inventory values, while the analyzed company is not — this can also signal some deferred recognition of those losses.
4. When the cash flow makes no sense…
Income numbers reported usually reflect what accountants call accrual accounting — which means the company does a transaction and the revenues and expenses related to that transaction are recognized at that time, even though the actual cash may change hands at a different date. This naturally would result in differences in the timing between profits and cash flows. However, the relationship between those two over time should generally be stable and predictable (if the company does not materially change its accounting policy). If that is not the case and, for example, the revenues begin to increase very fast over time, while cash flow does not — that could signal management making choices in the accounting in order to boost profits.
To boost cash flows, some companies use techniques to include some types of flows (such as financing cash flows) as cash flows related to normal operating activity. For example, if a firm asks for a collateralized loan with a bank against inventory as collateral, that is a financing transaction. But if the company considers this a sale of inventory, it will lead to an overstatement of operating cash flows. Another way to do that is to sell receivables before the date on which they are supposed to be collected (e.g. via factoring or securitization services). One should pay close attention to whether such transactions are present and visible in the statements.
As mentioned before for revenues and profits, non-recurring items can also be used to increase cash flows from operations. For example, income from litigation cases, one-time awards, or special situations (such as COVID) that allow delays in payments to vendors or building/office owners — all of those could be shown as operating cash flows, and the accounting methods allow for that. But those are clearly one-time payments unrelated to the usual business of a company.
5. What is NOT on the books?
Another way managers could try to boost profits is by not showing certain expenses. The way they can do that is, for instance, by deliberately not recording certain payments even though there are invoices for them, by negotiating special vendor rebates or credits that can be used to reduce the cost of sales in a specific period, or by not recording contingency reserves of unsettled disputes. Certain contracts oblige the company to make payments in the future e.g. to supply its operations with inventory or fund a specific new operation, business or project. As a result of that, an off-balance sheet commitment exists — which one should search for in the financial statement notes as it constitutes an additional liability for the company.
Some specific types of obligations are also shown off-balance sheet — like some leases or pension obligations, for example. If one ignores those when investing in a company, one can end up significantly underestimating the debt level of that company. In fact, when considering those correctly as part of the total liabilities, a firm may appear to have unsustainable levels of debt. Once again, be on the lookout for disclosures in the notes related to such future obligations as they could change your perspective.
6. Is this really worth that much?
Many companies hold resources that can lose value over time — e.g., tangible assets (such as machines and equipment) become obsolete, or intangible assets (such as goodwill as a result of business acquisitions) can prove to be less valuable to the acquiring company. And management sometimes has incentives not to recognize such losses in value — for example because it wants to avoid reporting them or reducing profits. Managing the methods of depreciation and delaying or preponing write-offs to boost either current or future profits, can be signs of manipulation that one should keep an eye on. Some indicators that point to that could be decreases in the turnover of long-term assets, in the return on assets below the cost of capital, or divergence with what other firms in the industry report when their assets use has deteriorated.
7. This company is very innovative!
Companies in many industries are constantly developing new technologies — whether it is large multinational tech corporations, automakers, social platforms, or fintech startups. An essential part of such innovative activities at those firms, there are research and development expenditures (R&D). And while accountants would tell you that there are specific rules when R&D should be capitalized (i.e. shown as an asset on the balance sheet) or expensed (i.e. shown as a cost/expense on the income statement — thereby reducing profits), one should be very vigilant about how management treats those — before investing in such companies.
Putting aside the accounting complexity here, one should know what effects that decision about R&D can have on financial results. If R&D is supposed to be expensed but is instead capitalized improperly, this will lead to a higher amount of assets and an increase in cash flows related to investment activities initially. Current earnings will appear higher than they should be, had an expense been recorded. However, further down the road, that asset would normally need to be depreciated — which means, recording an expense over time that reduces future profits and the asset value itself — without any effect on cash flows.
That kind of discretion provides managers with a way to mislead investors and analysts about the actual financial results of the firm. Analysts generally use cash flow to value companies — so not having an operating outflow with the capitalization decision could result in assigning higher values. If the opposite is done — and R&D is expensed — that might reduce profitability initially but would show a positive trend in the earnings numbers when following them over multiple years — an indicator analysts also follow for valuation purposes.
conclusion
Even though the summary of red flags presented here provides a good starting point to improve one’s understanding of any company before investing in it, it is by no means exhaustive. Paying attention to those warning signs is important because it enables investors to stay vigilant and avoid possible losses. Usually, the bigger the part of senior management compensation that is linked to reported financial results or stock price performance, the higher the incentive for managers to “manage” (or manipulate) earnings. One needs to stay informed and get as much financial, non-financial information, and context about any numbers presented as possible. This would help significantly reduce the probability of putting your money into the next Enron or the next Wirecard.
PS: I would highly recommend the book “Financial Shenanigans” by Schilit, Perler and Engelhart.
Author: Nikolay
Founder of MoneyCraft
