Hidden Red Flags
By Tom Jacobs (TMF Tom9)
January 16, 2003
A few handy screening tools can determine whether a
company's business is deteriorating. Dig deep into the
notes to its financial statements, where you may find clues
that the company is using aggressive, rather than
conservative, accounting to make things look better than
they are. In his fourth and final column in a series, Tom
offers some hints.
A few helpful screening tools can help you identify warning
signs for stocks. Then you can dig deeper to find out
whether you've got a sick business or one weathering a
normal storm. Or worse, you might find that the business is
using aggressive, rather than conservative, accounting to
hide signs of an impending day of reckoning.
Last week, I shared my plan of attack for analyzing
financial statements and covered two warning signs: 1)
accounts receivable and inventories growing faster than
sales, and 2) net income growing faster than cash from
operations. Now, on to the Flow Ratio, days sales
outstanding, and the cash conversion cycle.
Flow ratio increasing
Stronger companies can collect customer money faster and
put off paying suppliers longer. One way to capture this is
in a declining (good) or rising (not so good) Flow Ratio,
coined by our own Foolish co-founder, Tom Gardner.
Veeco Instruments (Nasdaq: VECO), an optical components
manufacturing and metrology equipment maker, carries a
rising Flow Ratio around its corporate neck. Here it is for
the last eight quarters:
Q1* 3.03
Q2 2.91
Q3 2.72
Q4 2.48
Q5 2.53
Q6 2.31
Q7 1.02
Q8 1.14
*Q1 is most recent reported quarter, Q2 second most recent, etc.
The Flow Ratio is increasing each quarter sequentially --
and year over year. In the best of all possible worlds, we
like a declining Flow Ratio and one less than 1.5. Sirens
go off above 3.0. My next step is to compare these numbers
against those of other companies in its industry. For
example, it's rare to find a software firm with a Flow
Ratio above 1.0, and the big drug makers hang out between
1.0 and 1.5 almost invariably. I need to look for both the
absolute number and the quarterly trend, both sequentially
and year over year.
[For more on this subject, check out this Motley Fool
resource: The Foolish Flow Ratio.]
Days sales outstanding increasing (and related goodies)
How long does it take for a company's customers to pay?
Increasing days sales outstanding (DSOs) and DSOs higher
than others in a company's industry are signs of a
deteriorating business.
And using DSOs, days inventory outstanding (DIOs), and days
payable outstanding (DPOs), investors can also compute the
cash conversion cycle (CCC) and find out whether it's
taking a company more or less time to convert one dollar
paid to suppliers into one dollar of income from
customers.
Here's a case in point that surprised me. Qualcomm's
(Nasdaq: QCOM) CDMA wireless communications advances have
upended its industry status quo and produced rivers of free
cash flow. DSOs for the recent quarter have increased 31
days sequentially and 23 days year over year. And its cash
conversion cycle -- the amount of time it takes it to
convert one dollar paid to suppliers into one dollar
received from customers -- has increased for the last three
quarters.
Qualcomm DSO DSI DPO CCC
Q1-Q2 +31 days +1 +16 +15
Q1-Q5 +23 days -10 +21 -10
Q1 97 + 26 - 61 = 61*
Q2 65 + 25 - 45 = 46
Q3 67 + 24 - 55 = 36
Q4 76 + 32 - 80 = 28
Q5 74 + 36 - 40 = 71
Q6 135 + 44 - 49 = 130
Q7 94 + 32 - 44 = 82
Q8 93 + 24 - 39 = 78
*Minor disparities due to rounding.
These numbers suggest its customers may be taking longer to
pay, and that earnings may be at risk. More attention to
the financials would tell you whether there's trouble ahead
for Qualcomm or if this is an anomaly.
Notice that I looked at both the CCC trends for the most
recent quarter sequentially and year over year. Some
changes may be seasonal and normal for the company, and
visible only with year-over-year comparisons. Notice that
while the CCC has increased, it's still below Q4 through
Q8. Changes in DSOs are the most potentially dangerous,
followed by DSIs. Beware of CCC improvement due to DPOs
only.
[For more on this subject, check out these Motley Fool
resources: How to Read a Balance Sheet and Show Me the
Money!]
Then what?
Once you have your warning signs from raw numbers, the
bodies are buried in the notes to the financial statements
in SEC Form 10-K and 10-Q. Howard Schilit's Financial
Shenanigans and Thomas O'glove's Quality of Earnings can
help you understand them and find out whether the company
uses conservative or aggressive accounting. While they
emphasize that DSOs, accounts receivable, and inventory may
point to potential aggressive accounting, the authors also
share many other indicators that management has prettied up
a worsening situation.
And while prettying up has its advantages, not so in
financials.
The fine print
What can you find in the notes? Schilit identifies seven
major shenanigans and explains them in detail, providing
real-life examples and tools for detecting them. They
include shifting expenses and revenue to different periods,
revenue recognition, recording bogus revenue, and more.
Some are easier to find than others, but all require
attention to the notes.
How does a company value its inventory? Has it changed from
FIFO (first in, first out) to LIFO (last in, first out), or
the other way? A change may be to improve the balance
sheet's appearance. According to Schilit, FIFO generally
produces higher profits in inflationary times than LIFO,
and vice versa. We want the most conservative approach.
What about software development expenses? If a company
starts capitalizing them out of the blue, and they show up
as assets on the balance sheet, look for an explanation in
the notes. Is there a project that has reached
technological feasibility (the accounting standard), or is
this all about making the asset side of the balance sheet
look better? And how large a percentage of earnings does
the capitalized software represent? The larger the chunk,
the more suspect the earnings.
It's easy to cruise for these and other key words in an SEC
filing online. Just type CTRL + F while you're in the
document on screen.
These are just two of the many items you can find in
Schilit and O'glove's books. If and when I learn to apply
them, I'll share in my regular columns.
Paralysis by analysis
I'm not looking for so much detail that I let the analysis
paralyze me, but I am curious (fellow). I want to know how
companies play with revenue recognition and how dividends
can be, in O'glove's words, the "tender trap." Knowledge
brings confidence and the ability to separate the important
from the less so. Two other references helping me along
this path are accounting professors Mulford and Comiskey's
The Financial Numbers Game. I say "reference" because it's
just too dense for me to read cover to cover. Tom Taulli's
The Streetsmart Guide to Short Selling is another useful
reference that explains the entire short-selling process
clearly and explains sell signs.
Flash: Kathryn Staley's The Art of Short Selling just
arrived in the mail yesterday and was so immediately
engrossing I stayed up way past my bedtime!
Starting out?
Get started reading financial statements with our How-To
Guide: Read Financial Statements Like a Pro, and go from
there to topic-specific follow-ups at Fool.com. Two great
books to grab are John A. Tracy's How to Read a Financial
Report and Accounting for Dummies. Anyone who follows these
paths can certainly move right into the Schilit and O'glove
books. None of this is rocket science. It just requires a
little effort and interest.
This is the fourth and final column on the steps I started
taking in 2002 to position my portfolio for life-long
investing success, but it doesn't end here. I want these
issues to be in the forefront of all my writing and
analysis this year. Finding the right percentage of risky
investments for comfort, employing valuation models more
carefully to buy and sell, identifying financial warning
signs, and learning more about conservative versus
aggressive accounting will make everyone a more effective
investor.
Until next week, have a most Foolish weekend!
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I'm really interested in what you folks think of this, especially you financial gurus. |
