Identifying red flags in practice

In simple terms

A red flag is a sign that something may be wrong: with the accounts, the business or the people running it. The financial red flags lesson listed the common ones. This lesson is about applying them in practice: working through a company's filings, judging how serious each finding is, and deciding what to do next.

A working checklist

Go through the company's statements and filings with these questions:

Earnings and cash

• Does operating cash flow keep up with profit over several years, as the statement analysis lesson explains?
• Are receivables or inventory growing much faster than revenue?
• Are large costs being capitalised rather than expensed?
• Are there frequent "one-off" items?

Balance sheet

• Does the company report large cash balances while also borrowing heavily at high interest rates?
• Are there large loans or advances to related parties or little-known entities?
• Is goodwill or other intangible assets rising quickly?

Governance

• Has the auditor resigned, been changed often, or qualified the accounts?
• Are related-party transactions large or growing?
• Are promoter shares heavily pledged?
• Have independent directors or senior finance staff left suddenly?

Disclosure

• Have key metrics or segment definitions changed?
• Are results filed late or corrected?

Ranking severity

Not all red flags are equal.

Clusters matter most. A company with profit far above cash flow, receivables doubling, large sales to related parties and an auditor change is a very different case from a company with just one of these.

Questions, not accusations

A red flag is a reason to look closer, not proof. Rising receivables can come from a large new customer with long payment terms; an auditor change can be routine. Write each finding as a specific question, then look for answers in the notes, the annual report, earnings call transcripts and rating agency reports.

If good answers cannot be found, that is itself important. Many investors simply avoid companies whose numbers they cannot understand.

Large companies are not immune

It is tempting to think red flags belong to small, obscure companies. History shows otherwise. Satyam Computer Services was one of India's best-known technology companies when its chairman admitted in January 2009 that its accounts had overstated cash and bank balances by thousands of crores, as the accounting fraud case study explains. Size, reputation and famous auditors did not prevent it.

Why it matters

Losses from accounting problems and governance failures can be total and sudden. Systematically looking for red flags is one of the few defences an outside investor has. Even when red flags do not reveal fraud, they often reveal a weaker business than the headline numbers suggest.

Limitations

Determined fraud can be hard to detect from public filings, and the flags can appear only late. Many red flags have innocent explanations, and treating every one as fatal would rule out many sound companies. Judgement is needed.

Common mistakes

• Dismissing red flags in large or popular companies.
• Treating one flag as proof.
• Looking at items one at a time instead of in combination.
• Moving on to valuation before resolving serious concerns.

Try it yourself

1. Work through the checklist above for a company you are researching, using at least five years of filings.
2. Rank each finding by severity.
3. Write each as a specific question and note where you might find the answer.
4. Decide whether any finding, or combination, is a deal-breaker for you.