Classroom | Red flags in financial statements; how to read income, costs, interest (Equity: Part 24)

True and fair picture is a term that one associates with the audited financials of a company. That is part of the independent auditor’s report to shareholders, after having studied the accounts, running random checks, questioning the management on any unusual transactions, and doing everything else prescribed in the audit procedure for companies. There is the credit rating agency that gives a rating after analysing a company’s financials. A good rating should mean all is well.

In 2019, the average investor may laugh at these assertions and retort with that cliché, nothing is what it seems. Companies that cleared successive audits for years are now being accused of having cooked the books. The auditors were misled or worse, hand in glove with the management. Rating agencies believed everything they were told and if they were lied to, then their rating was always fairly useless.

What is an investor to do then? Here is a primer on what investors should look for in the financials of companies, to know if all is well or not. But here’s a caveat. If trained auditors and qualified financial analysts of a rating agency are unable to spot them, and so too all the institutions that recommended or invested in these stocks, investors should remain sceptical about their ability to do so.

It will require a fair amount of time and understanding of financials. Moreover, if a group of individuals—a company may be a legal entity but it has no life, humans run it—are determined to commit fraud, it may indeed be too late by the time an investor finds out.

Still, here are some tips on where and what to look for.

Income: When a company is showing unusually high-income growth, compared to what its peers are showing, then it’s something to be watched for. This is particularly true when it’s relatively easy for some industries, where it may be easier to show higher growth. For instance, in industries such as automobile or cement volume, volume sales are publicly tracked so those numbers cannot be fudged easily. But in industries such as very basic commodities or even something as sophisticated as software, revenue can be manipulated. In such industries, peer comparison is a useful method to spot unusual trends.

Expenses: Since income, less expense is what contributes to profits and profitability, manipulating expenses is the next way to boost profits. This can happen in multiple ways, sometimes companies capitalise certain expenses which may be flagged by the auditor. For example, a company may add an expense to a fixed asset instead of charging it to the profit and loss account. That may inflate the profit by that extent.

Any unusual change in the various heads of expense should be kept track of. Also, the big costs as a percentage of total costs or revenue should be similar across industries. If it’s not, look for reasons that may explain the difference. If none exist, then that’s something to be worried about. For example, the freight cost/sales of two cement companies in the same region should be the same while it could vary for those in two different regions. But a different freight approach—say one company does it in-house while another outsources the function—could also explain it.

Miscellaneous expenses can hide a lot. One should feel a bit uncomfortable if this head is very high, especially higher compared to what peers are showing.

Interest: When companies borrow, there are times when they do not expense interest in the profit and loss account. At times, this may relate to the project because it has not formally started up. Check to see if this is going on for too long or auditors have commented about it. Also, sometimes, companies don’t expense interest, when the underlying debt is a structured one. Where it could be converted into equity or repaid in one shot at the choice of the lender. This can hide the obligation of the company.

(In the next part, we will look at how to read schemes of arrangement, working capital and cash on books)