Red zone; Yellow zone or Green Zone in investing

There are a multitude of cautionary red flags present in financial statements of any company. A pretty common part of the daily grind. But the catch is, a red flag does not simply imply window dressing of accounts, artful accounting or a fraud, but red flags essentially highlight areas of concern in the financial statements, that require deep scrutiny. So by carrying out a further synthesis, investors and analysts can come to an informed conclusion, given that a solid reason is presented to eschew and neglect the concerns.

 

One must be aware of the three primary financial statements: the profit and loss statement, balance sheet and the cash flow statement. Elements in each of these statements can fall prey to manipulation and meddling. 

 

Figures such as revenues, expenses and profits can be meddled with to display favorable margins and reflect a positive growth trajectory of the company. For instance via their tax structuring processes or debt structuring practices (which may in some cases be legal as well). The discrepancies in depreciation as per companies laws and income tax laws can be maneuvered to inflate profits. Firms that showcase a sharp deceleration in tax payment highlight areas of concerns as these practices can be utilized to inflate profits. 

 

The presence of excessive cash in the books that is not invested to generate productive income for the business say via FD or investment in liquid assets can raise a red flag amongst the investor and analyst community. Revenue recognition policies of companies can be tricky and hence a matter of concern to scrutinize. The elements that are usually prone to manipulation are namely: receivables and inventory. A significant surge in receivable days compared to revenue growth requires a detailed scrutiny to ascertain the authenticity of the revenues. Some firms may recognize revenues inflows earlier than they should report. For instance subscription service companies may recognize revenue say Rs15000 per customer for a year at once outright, than reporting Rs 1250 every month for the 12 months. If un-billed revenue is higher than billed revenue it can raise serious concerns. Hence creating an illusion of increasing revenues and profits in the income statement. 

 

In fundamental investing investors search for companies that are zero debt however if companies hold excessive debt and borrowings, that is clear point of concern. It is imperative to read notes that elaborate information mentioned in the different financial statements. Transactions to related parties like excessive remuneration or loans or sale & purchases, can be a matter of concern as profits can be distributed between known individuals and not reported in the profit and loss accounts. 

 

Some companies capitalize their expenses like R&D, interest expenses hence reducing expenses in their profit and loss statement. Such practices call for a detailed scrutiny. Suspicion should arise in the case of a rise in profits despite a decline in revenues through one off incomes. Firms that are involved in a lot of acquisitions can present misleading figures by displaying or recognizing rising revenues not from their core business but by the acquired company (that they now own). In addition exorbitantly priced acquisitions under the justification of acquiring intangibles like goodwill smacks for suspicion.

 

Ambiguous expenses on assets such as excessive spending on computers per employee, purchase of equipment that costs higher compared to their industry counterparts or baseless CAPEX activities totally unrelated to core businesses can raise eyebrows in the analyst and investor community. Operating cash flows being significantly lower or negative compared to operating profits seems an obvious reason of suspicion and requires detailed scrutiny.  

 

There are other critical factors that raise alarm in the inventory and analyst communities such as frequent change in auditors of the companies or recurring negative comments and remarks by the auditors on the company’s financial statements. A boastful management that enjoys excessive remuneration compensations is a big no for investors as the management is not investor friendly. Abrupt exits of members of the management can raise questions. A management lacking competence will go leaps and bounds to grow their business to attract investments. They try to create an image of a business that is well done and must obtain investment to perform better though the money may go into thin air

 

So, when do promoters or managements choose the wrong path? Where does this manipulative instinct rise from? 

 

The simple answer is: Greed and Fear. 

 

The stock market thrives on the concept of greed and fear as the transactions between buyers and sellers would not take place if they were not influenced by greed and fear. As warren buffet states be greedy when others are fearful and fearful when others are greedy.

 

Whilst this game of greed and fear is played between investors surprisingly many promoters and managements of companies join the bandwagon to inflate their share market valuation and business valuation than rely on their knowledge, skills and talents to nurture their company to organically obtain the high prices and market cap. 

 

Promoters are influenced by greed to increase the stockmarket valuation (short term view) in the market. Ignoring the miracles of long-term growth by expanding business operations through reinvestment of earnings and increasing operational productivity, leading to rising revenues and profits eventually translating in their rising earnings and higher business valuation. A more justified way to expand the value of the business. Clearly the best path to follow. 

 

Some promoters may fall prey to greed to perform better than their competitors in terms of market capitalization of their companies and resort to unhealthy accounting practices deceiving investors.

 

Ego clash with self for promoters can lead to unhealthy thoughts if unable to meet promised targets they announced publicly. Fear of loss in reputation may haunt them to take the wrong path however this loss in reputation would be short lived v/s loss in reputation that can take place on a larger scale by following wrong accounting practices. Hence promoters shall have the ability to accept their mistakes, accept the fact that a decline in performance is short lived and they can bounce back as every business has a cycle of growth. 

 

Promoters and managements that are under pressure to maintain high growth can get misguided to take the wrong steps. Firms that frequently raise money can raise red flags hinting at wrong doings/ wrong capital deployment by the management for their benefit.

 

All in all red flags themselves do not mean wrong practices or fraud, but the presence of red flags definitely requires a detailed scrutiny and analysis at ground level. Investors shall be weary of certain aspects related to accounting to be able to spot suspicious data, hence making prudent decisions for investments.

(Disclaimer: The opinions expressed within this article are personal opinions of the author. The facts and opinions appearing in the article are views of the author in general and the author does not hold any legal responsibility or liability for the same.)