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Forensic Files
Danger signs, red flags, damn spots call them what you will. Fools have been running the numbers on prospective investments since at least as far back as 200 B.B.E. (Before the Buffett Era). Those were simpler times, perhaps, but it wasnt long before some renegade accountant concocted the first accounting shenanigan and the very first balance-sheet gumshoe cried foul. Hard to believe that from such humble beginnings sprung an entire cottage industry and a devilish moniker: forensic accounting. Forensic accounting? Think Warren Buffett and a dash of CSI: Miami (its warmer there, if nothing else). In Rockville, Md., just round the beltway from Fool HQ, Howard Schilits Center for Financial Research and Analysis is a particularly high-profile, high-end player in this wildly profitable business. Rivals hunker down at regulatory agencies, investment banks, and money management firms on Wall Street and Carnaby Street. We wont burden you with their level of sophistication, much less expense, nor do we need to. We can dig up more than enough dirt in just a few minutes.
A Hill of Beans
For all the glamour and intrigue, forensic accounting starts and ends with financial statements. We have already alluded to creative accounting or accounting shenanigans. Essentially, this entails aggressive or fraudulent reporting of a companys business results or financial condition. Entirely aboveboard, accurately reported results are just as important to inspect; if you know where to look, you can spot trends that reveal deterioration in a companys business. But before we dig into all that, lets step back even further. If you really think about it, financial accounting or more precisely, the ways in which a company opts to regard and report its financial results offers a very clear window into the inner workings, even the character, of that companys leadership. And when you get right down to it, its hard to imagine a good business without good, honest leaders at the helm. The nuts and bolts of accounting can wait, at least until we get a good look at management for danger sign No. 1.
6 Danger SignS
1 Management Churn or Scandal
Leaders come and go be sure you know the reasons why.
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jury duty. Youre no hangman; youre merely taking a pass on a stock. If a companys financial reporting has ever gotten so tangled that it was forced to miss or put off a quarterly or annual filing, tread lightly. Management will do almost anything to avoid a delayed filing, so if the firms stumbled this badly, it can be really bad news. So how do you know? Earnings and accounting restatements are not the types of things companies like to broadcast to prospective investors, but neither are restatements easily swept under the rug. First, search the companys two or three most recent annual reports (10-K) or better, annual proxy statements (DEF 14A). Both are available online (on Fool. com, when you get a quote for a particular stock, simply click the SEC Filings link for a list of recent filings), and both offer a wealth of information for prospective investors. If these turn up empty, try searching for news on the company using your Internet search engine of choice, using keywords like accounting and restatement. Since companies have to file earnings restatements with the SEC, they invariably show up in news articles and press releases issued by the company. This might sound like a bit of work, but its a sure way to get to know any company you own.
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the tried-and-true, the debt-toequity ratio. To get started, grab the value for total debt off the companys latest balance sheet and slap it atop the value for stockholders equity. By comparing debt to equity, we get a feel for the resources a company might possibly toss out to keep the wolves at bay should they show up at the door. Youve probably weighed your own obligations against your own personal possessions (if youre like us, about 30 times a day). You certainly want to have more than you owe (a debt-to-equity ratio less than 1, preferably comfortably less). Just as importantly, when it comes to investing, you really dont want your horse carrying more debt than its rivals. After all, while things may well go swimmingly, if the economy or sector turns sour, it can be a long way down, especially for those with the biggest loads (think WorldCom). The beauty of investing (sadly, unlike day-to-day life) is that you never, ever have to roll the debt dice.
on any one days sales. If this number is growing over time, you could have a problem; if it exceeds industry norms or what youd consider reasonable credit terms (for example, 60 days), you most assuredly do. Again, creeping receivables can be caused either by bad business or by bad business practices. Either way, you dont want to see accounts receivables growing more rapidly than sales. Not only because of what this implies directly, but because, like characters in a bad sitcom, fear of discovery could goad ordinarily law-abiding (if morally irresolute) managers into ever-more creative accounting or outright fraud.
living on a praYer Were halfway there. The first three danger signs clearly sport a scandalous hint of ... well, scandal (or at least poor judgment). But like we said, bad things sometimes do happen to good people. Our remaining danger signs deal with what might be termed business deterioration. All three can result from creative accounting, but each might also afflict rigorous, thrifty, and downright ethical leaders. Give them the benefit of the doubt if you like, but managements good intentions in no way mitigate the threat to your portfolio. All three of the following can lead to the dreaded accounting restatement, and all three are signs you dont want to see, beginning with No. 4.
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burgeoning inventories are susceptible to one quick test. Ever notice how when Wall Street says results, it really means earnings? Well, surprise! Reported earnings (a.k.a. net income) is the favorite target of creative accountants. Its a sitting duck. And when you get right down to it, cash is what matters anyway. You can learn a lot just by comparing cash flow to net income. Put plainly, you dont want net income increasing when cash flow isnt. Fortunately, companies are required to report their sources and uses of cash, as well as their cash on hand for the most recent years in their annual reports. Its all laid out right there on the statement of cash flows. And not only is the statement of cash flows easy to use, its extremely difficult for management to abuse. All we have to do is seek out the statement of cash flows, pluck the value from the top line (net income) and the value from a few lines down (cash from operations), and voil. The trick here is to compare the changes from one year to the next. If you find that net income is increasing at a faster clip than cash flow, beware. If earnings are rising year to year and cash flow is not, danger! Either way, somethings not right. And while the fact that earnings are rising faster than cash flow doesnt necessarily mean that management is up to no good, its never a good thing. Maybe receivables (customer IOUs) are filling the coffers because customers are struggling to keep up, or maybe customers just arent buying, leaving the shelves stocked with inventory. Theres no crime in either, but both increase net income relative to cash flow, and so both are ominous signs.
Conclusion
So, there you have it: 1. Management churn or scandal 2. A history of restatements or late filings 3. Excessive debt 4. Disproportionate growth in accounts receivables 5. Disproportionate growth in inventories 6. Insufficient cash flow relative to earnings These six danger signs are easily unearthed and almost invariably spawn turmoil somewhere down the road. And while none carries a mandatory death sentence, all can mean trouble for your portfolio. Take our word for it youre better off without them.
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