Question

What are some common red flags in financial statement analysis and what steps should be taken in the event that we notice a red flag when analyzing financial statements?

Answer 1

Red Flags mean indications of probable trouble.The Financial Statements are quite capable of reflecting these warning signs.Some of the common Red flags could be -

• Manupulated Revenue Figures - Sales to related entities , Generating INcoices to spike revenues when actually goods have not been dispatched , recognizing consignment Sales as completed Sales , delaying recording of Returns.Analysis of revenue trends over different reporting periods can expose these inconsistencies.
• Under/Over Provisioning- This is another commonly used method of manupulating the financials.In order to inflate profits expense under provisioning is adopted and reverse is done when profits have to be shown at a lower levels.The underlying assumptions in creating these provisions have to be analysed so that accuracy of same gets established.
• Increasing Collectibles: The growth in top line could be because of a loose policy aroung credit period offered or compromises with customers credit ratings.In such cases though top line gives a picture of growth but the cash inflow may not be there and bad debts might be waiting to hit.
• Pending Class Law suit: These could be lead to hit the financials in near future and no sufficient provisioning would be in books by Organization so that picture looks perfect.
• Inventory Valuation: Policy adopted for Inventory valuation is also an indicator.If there are changes then reasons for same need to be checked.
• Depreciation Rules: Depreciation method could be changed without sufficient basis to have lesser impact and improve the Profits.

Investors take decisions based upon the Financial Statements.One of the key aspects for Investors while analysing the Financial Statements is to keep an eye on the above aspects.In case there are any red flags observed a further detailed trend analysis and management comments need to be read through.If convinced on that warnings are true then Investor should keep away from such companies.Often Auditors are also miss out on nuances and hence blindly relying on the audit certifivation too is not recommended.