7 Red Flags That Indicate a Company Might Be Manipulating Its Financials: Insights from 'Financial Shenanigans

In the world of investing, it’s crucial to stay alert for any potential signs that a company might be manipulating its financial statements. “Financial Shenanigans,” a book by Howard M. Schilit, explores various accounting tricks that companies use to present a more favorable image to investors. Understanding these red flags can help investors avoid falling into traps set by management teams with questionable practices. In this article, we’ll dive into the 7 most common red flags that indicate a company may be cooking its books.

1. Distorted Account Receivables

One of the most common tricks used by companies to manipulate their financials is the distortion of account receivables. This can be done in several ways:

Selling receivables to hide revenue problems.
Reclassifying receivables into other categories to hide deteriorating cash flow.
Changing Days Sales Outstanding (DSO) to make it appear as though the company is collecting payments faster than it actually is.

Why it matters: If a company’s DSO keeps increasing, it could indicate that it is recognizing sales before collecting cash, which is a sign of potential revenue manipulation.

2. Inflating Inventory Metrics

Another common financial shenanigan is the manipulation of inventory metrics. Companies may:

Classify certain inventory as noncurrent, indicating that the inventory will not be used within a year.
Exclude in-transit or warehouse inventory from inventory turnover calculations to make it seem more efficient than it is.

Why it matters: A sudden increase in inventory or a decreasing inventory turnover ratio can be a warning sign. This could indicate that the company is holding obsolete inventory, which it’s not yet writing off to avoid taking a loss.

3. Hiding Impairment Problems in Financial Assets

Financial institutions are especially prone to hiding problems with their loan books by manipulating the presentation of their assets.

Delaying the recognition of impairments.
Reclassifying bad loans or assets to make them appear healthier than they are.

Why it matters: Financial institutions that fail to write down non-performing assets are effectively inflating their balance sheets, misleading investors about the company’s true financial health.

4. Non-Standard Business Performance Metrics

Many companies create non-standard performance metrics that aren’t part of traditional accounting standards. These can be manipulated to present a more favorable picture of the business. Common examples include:

Same-store sales: Management may change the eligibility criteria for stores to make the company look better.
ARPU (Average Revenue Per User): Companies may manipulate the components of ARPU to show a higher revenue figure.
EBITDA vs PAT: Some companies focus on EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) to avoid showing the full impact of operational costs like depreciation and interest.

Why it matters: When management creates new metrics, they may change the definition to present a more flattering picture of the business, leading to misinformed investment decisions.

5. Manipulating Cash Flow

Cash flow is a crucial indicator of a company’s financial health. However, some companies may try to manipulate it by:

Capitalizing operating expenses, which inflates both earnings and cash flow.
Presenting cash earnings (PAT + Depreciation) or EBITDA rather than CFO (Cash Flow from Operations) to highlight the company’s “better” cash position.

Why it matters: Inflating cash flow can make a company seem more liquid and profitable than it truly is. It’s essential for investors to focus on Free Cash Flow (FCF), which accounts for capital expenditures, rather than just CFO.

6. Frequent Changes in Accounting Policies

Companies that frequently change their accounting policies may be doing so to hide financial issues. Common changes include:

Revenue recognition policies.
Depreciation methods.
Changes in fiscal year-end to manage earnings timing.

Why it matters: When accounting policies change, it can be an indication that the company is trying to manipulate how its financial performance is reported. Be wary if a company frequently alters these policies without a clear and logical reason.

7. Acquisitions to Boost Cash Flow

Acquisitions can sometimes be used to manipulate financial results:

Inflating CFO (Cash Flow from Operations) by including the acquired company’s receivables as cash flow.
Treating acquisition costs as capital expenditures to avoid recognizing them in operating cash flow.

Why it matters: Acquisitions can create a misleading picture of the company’s financial health by boosting cash flow artificially. Investors should carefully examine the details of acquisitions to ensure they aren’t just a tool for masking underlying issues.

FAQs

Q1: How can I detect if a company is inflating its earnings? Look for signs like an increase in accounts receivable without a corresponding increase in cash flow. Additionally, compare cumulative Cash Flow from Operations (CFO) with Profit After Tax (PAT) over the years. If CFO is consistently less than PAT, it’s a red flag.

Q2: What should I look for in a company’s inventory metrics? A decrease in inventory turnover or a rapid buildup of inventory could indicate that the company is carrying obsolete or slow-moving products. It might be a tactic to delay recognizing impairments, affecting profitability.

Q3: Is EBITDA a reliable metric to evaluate a company’s performance? While EBITDA is useful, relying solely on it can be misleading. It excludes critical expenses like depreciation, interest, and taxes, which are vital for certain businesses. Always consider the full picture, including net profit and cash flow.

Q4: What does an increasing Days Sales Outstanding (DSO) mean? An increasing DSO suggests that the company is not collecting payments as efficiently as it should be. This can indicate that the company is inflating its revenue figures without collecting cash, which is a potential manipulation of earnings.

Q5: Why is Free Cash Flow (FCF) important? FCF gives a clearer picture of the company’s ability to generate cash after accounting for capital expenditures. If FCF is declining while CFO remains strong, it’s an indication that management may be manipulating cash flow or capitalizing operating expenses.

Conclusion

Understanding the financial shenanigans companies may use to distort their financials is crucial for investors. By staying alert to the 7 red flags outlined above, you can safeguard yourself from making poor investment decisions. Always dig deeper into financial statements, question the use of non-standard metrics, and keep an eye on cash flow to spot any manipulation early on. By doing so, you will be better equipped to make informed investment decisions and protect your wealth from financial manipulation.