Harry Domash's Winning Investing


Spot Accounting Red Flags the Easy Way
Use cash flow to detect creative accounting

It’s bad news when one of your holdings reduces its earnings forecasts, or actually reports earnings below expectations. Such events usually trigger a substantial share price drop. 

That’s why some investors go to great lengths to detect “red flags” warning of future earnings shortfalls. But that kind of analysis entails taking calculator in hand and digging into financial statements. Many investors don’t have the time it takes to perform a detailed financial statement analysis. Here’s the good news: there is an easier way by comparing cash flow to net income. 

Let me define the problem before getting to the details. 

Why Creative Accounting? 
Firms often experience fast growth during their early years. During these heady times, everybody involved assumes that the strong growth will continue indefinitely and the stock price invariably reflects those expectations. But eventually the firm begins to saturate its market and the growth rate falters.

Since a growth slowdown will sink the share price, some managers resort to creative measures to mask the falloff. For instance, they may encourage customers to order unneeded products by offering longer payment terms (e.g. one-year instead of the usual 60 days), a practice known as “channel stuffing.” Another way to stimulate demand is to cut prices. Of course reducing prices without corresponding cost savings decreases profit margins and hence earnings. But that result can be masked by inflating inventory dollar values, which increases margins.

These high jinks leave tracks. Channel stuffing increases accounts receivable (monies owed by customers) levels since customers are taking longer to pay. Profit margin manipulation abnormally increases inventory values. 

Detect Creative Accounting
Savvy investors detect these shenanigans by watching for unusual increases in accounts receivable or inventory levels. But there is an easier way. 

I’ll explain, but you first need to know a couple of definitions.

  • Net income is the after-tax profits figure that is divided by the number of shares outstanding to determine the all-important earnings per share figure.

  • Operating cash flow measures the cash that moved into, or out of the firm’s bank accounts resulting from its main operations. Cash flow is difficult to manipulate since it must be reconciled to actual bank balances.

The accounting hanky panky that I described earlier increases earnings, but not cash flow. For example, extended terms means that the company isn’t receiving its usual payments from customers. 

Compare Net Income to Cash Flow
Recent academic research found that you could detect these accounting tricks by simply comparing net income to operating cash flow, instead of digging into the details. What you’re looking for are instances where net income increases, but cash flow doesn't. You can find both figures on the cash flow statement. Here’s how to do it. 

Because quarterly cash flows are volatile, the analysis works best using annual numbers. Morningstar’s new 10-years financial report is ideally suited to the task. The report shows condensed versions of a firm’s income statement, cash flow statement, and balance sheet, in separate columns for each of its last 10 fiscal years.

I’ll use camera maker Concord Camera (ticker symbol LENS) to explain the process. From Morningstar’s home page (www.morningstar.com), get a price quote, select Financials (10-years), and then scroll past the income statement to the cash flow statement. There, net income is the top line, and cash from operations is four lines down.

Concord wasn’t consistently profitable until its 1998 fiscal year (June 1998) when it reported earnings of $6 million. Earnings rose to $7.7 million in 1999 and then shot up to $19.6 million in fiscal 2000. But operating cash flow told a different story, falling 45 percent in fiscal 2000 from 1999. That was a red flag, since earnings more than doubled, but cash flow declined.

The signal worked! Earnings turned into losses the next year. Concord filed its June 2000 annual report on August 30, 2000. You would have had plenty of time to analyze the report before Concord’s share price peaked near $40 in mid-October. Earnings shortfalls drove it down to the $5 range a few months later.

I found similar examples for outsource manufacturer Jabil Circuits, Gateway Computer, Ford Motor, Lucent Technologies and software maker Autodesk.

The occurrence of rising earnings combined with falling cash flow doesn't necessarily imply accounting shenanigans. Accounts receivables could increase because customers don’t have the cash to pay. An unforeseen sales slowdown could push inventory levels up. However, these events could also foretell an earnings slowdown. 

Don’t’ take my word for it. Morningstar’s report format makes it easy to look up your own stocks and determine whether the correlation between rising earnings and falling cash flow signals future earnings declines. You don’t even need a calculator.
published 12/15/02


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