Financial red flags

In simple terms

A red flag is something in a company's accounts or disclosures that is not proof of a problem, but is common before problems emerge. Some red flags have perfectly innocent explanations. Others turn out to be the first visible sign of a business in trouble, aggressive accounting or fraud.

The skill is not to panic at every flag, but to notice them, ask why they are there, and give heavy weight to several appearing together.

Red flags in profit and cash

Profit that does not become cash. Operating cash flow consistently well below net profit, as the quality of earnings lesson explains. Innocent explanation: fast growth tying up working capital. Worrying explanation: revenue that is not real or will not be collected.

Receivables growing much faster than sales. Innocent: longer credit to win business. Worrying: sales recorded early, or to customers who cannot pay.

Inventory piling up. Innocent: stock built ahead of a busy season. Worrying: unsold or obsolete goods carried at too high a value.

Large or growing other income. Interest, gains on investments or unexplained "miscellaneous" income propping up profit while the core business weakens.

Exceptional items every year. "One-off" charges that recur are ordinary costs, and "one-off" gains that recur may be engineered.

Capitalised costs growing fast. Running costs moved onto the balance sheet to lift profit, with large write-offs later.

Red flags in the balance sheet

High cash and high debt together. A company with large reported cash balances should not need to borrow heavily at high interest rates. Sometimes there is a good reason, such as cash held abroad or in a regulated subsidiary; sometimes the cash is not really available, or does not exist.

Loans and advances to group companies, especially large or growing ones that are not repaid.

Large contingent liabilities, such as guarantees for group companies or disputed claims, compared with net worth.

Goodwill and intangibles growing faster than the business, often from acquisitions or capitalisation.

Red flags in reporting and governance

Auditor's report. A qualified, adverse or disclaimer opinion, or an emphasis of matter on going concern, is among the most serious warnings, as the auditor's report lesson explains.

Auditor resignation, especially mid-term or with reasons such as lack of information or disagreements.

Frequent changes of senior finance staff, such as the chief financial officer.

Changes in accounting policies or estimates that consistently raise profit.

Delayed results or restatements of past figures.

Complex structures and many related-party dealings, as the related-party lesson explains.

Promoter pledging rising sharply, as the pledging lesson explains.

Combining the flags

What to do when you see a red flag

1. Read the notes and the MD&A for an explanation.
2. Check the trend: a one-year blip is less worrying than a multi-year pattern.
3. Compare with peers: is the pattern normal for the industry?
4. Look for other flags that would confirm or contradict the first.
5. Judge the explanation: specific and verifiable, or vague and shifting?

If you cannot get a satisfying explanation, the safest choice is often to avoid the company. There are many others to choose from.

Why it matters

Accounts are prepared by the company, audited, and then read by investors who usually cannot check the underlying records. Red flags are the outside reader's main defence. Many large corporate failures and frauds showed several of these signs well before the collapse.

Limitations

Red flags produce false alarms: many companies with one or two flags are perfectly sound. And skilled frauds can avoid obvious flags for a long time. Use red flags to decide where to look harder and how much caution to apply, not as a mechanical test.

Common mistakes

• Treating a single red flag as proof of fraud.
• Explaining away several flags one at a time.
• Ignoring auditor and finance staff changes.
• Trusting management's explanation without checking it against the numbers.

Try it yourself

Choose a listed company and its last three annual reports.

1. Work through the red flags in this lesson and note which, if any, appear.
2. For each one you find, look for an explanation in the notes or MD&A.
3. Rate each explanation as convincing, partial or missing.
4. Decide whether the overall pattern calls for caution, and write down why.