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Danger Signals in Financial Statements

8 January 2007 - Features - Editor

Financial institutions and large investors have a crucial advantage over small stock market operators: they can interact with management teams, ask searching questions, and even demand affirmative action for changes they would like to see. The ‘small guy’ has to go by statutory statements and financial declarations-he or she cannot look beyond historical numbers. Now we must have the grace to accept things we cannot change, so how can we study financial statements to look after our stock market interests better?

There are 3 primary danger signals that may signal to the individual investor that things may be going awry with a company:

  • Sales grow faster than profitability. There are some arguments in favor of growing market shares, but they are most often experiments with your capital! Favor companies who put your returns and appreciation above capturing and holding customers.

  • Provisions and write-offs. Lean periods are the worst, because managements may prevaricate about some large tax, litigation, and disputed receivables, which could give you nasty surprises in future.

  • Controllable expenses. This needs a powerful microscope in good times! Are executives splurging on self-promotion? Have Advertising agencies conned management teams in to campaigns with diminishing returns? Are surges in profits relaxing cost effectiveness guards?

It remains to be said that not everything worthy of note makes it way in to statutory financial statements. Even retail investors on a stock market may get occasional opportunities to interact with top brass and ask uncomfortable questions. Here is a list of 3 to keep in your wallet or PDA, ‘ready to fire’ whenever you have a chance:

  • Does the company continue with products which make losses on a total cost basis, or which have marginal returns?

  • Are their slow moving items in the company’s inventories which will impact real profits, or even cause losses through eventual write-offs?

  • What is the sensitivity of projected returns on new investments with respect to key assumptions?

It is not easy for a retail stock market investor to discern all relevant investment information about companies, but these insights may help better foresee potential reporting problems on financial statements.

 


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