Investing Advice

Red Flags to Look For When Investing?

Watch out for sales growing slower than accounts receivable or inventory. Look at the balance sheet to see if there are falling reserves for bad debt, or an increase in deferred revenue.

If cash flow from operations is increasing or decreasing at a different rate than net income, this may be an indication that net income is being manipulated.

Fuzzy accounting didn’t begin with Enron or WorldCom. From 1998 to 2000, 464 corporations re-stated their financial statements with the SEC, wiping out a combined $31.2 billion earnings in 2000 alone.

Kroger, the country’s largest grocery chain, disclosed that the manager’s of their Ralph’s chain had padded $14 million to sales, moving money from the company’s general fund.

Other companies have done “channel stuffing”, getting customers to receive goods that would not have to be paid (or could be returned) until the following year, and claiming the sale and profit now.

Why do these companies use accounting tricks to nudge earnings a penny or two to meet Wall Street’s estimates?

The trend to tie executive’s pay to how well the company’s profits perform as well as how well the stock performs, puts many managers under pressure to play games with the numbers.

The top reason management is concerned with the stock price, is because their stock options will be worthless if the price falls. Their jobs may also be on the line, since key board members generally hold large blocks of stock, and don’t like watching their fortunes melt away.

How badly can the market react to a company missing its earnings estimate?

On July 2, 2002, First Horizon Pharmaceutical, which had been trading above $20 for the past 12 months, warned that it would make less the 2 cents per share (instead of the anticipated 8 cents) for the quarter. The stock had closed at $18.24, then based on the earnings news, opened the next morning at $5.96, and then immediately dropping down to $4.46.

Pro-forma financial statements

As long as a company abides by the standard accounting rules and is mentioned in the footnotes, anything goes on “pro forma” statements. Pro forma means “as if”.

Wall Street seems to fixate on whether companies meet quarterly earnings projections. This has caused company management to be scared to death of even being a penny under estimates. So to postpone the news that things aren’t as rosy as analyst’s expectations, they cheat to keep everyone happy.

It is a common practice to leave off a lot of “one-time” expenses from the pro-forma statements as if they didn’t exist. The problem with this is that in any company, there will always be extraordinary write-offs and expenses. While many unusual costs may not be part of a company’s core operating overhead, they are still real costs that they actually let happen, and so should not be separated from the bottom line.

It doesn’t matter if it’s dead inventory like Cisco’s $2.2 billion in 2001, or Ford Motor’s $3 billion cost of replacing Firestone tires. Things happen and investors should use their judgment in evaluating the current and long-term effects from such “one-time” costs.

Other Stock Market Basics Topics:

  1. Stock Market Investing – the Right Way
  2. More Stock Marketing Investing
  3. How to Pick Winning Stocks
  4. The Golden Rule of Investing
  5. Avoid Psychological Traps to Have Successful Investing
  6. Changes in Stock Values Can Be Big Numbers
  7. How to Invest Smart
  8. Stock Advice - Important Selling Rules
  9. Poor Stock Buying Decisions
  10. Market Indicators
  11. Stock Market Cycles
  12. When a bear stock market may not be a bear market
  13. Stock Index Futures
  14. Four Things that Affect Stock Valuation
  15. What is a P/E ratio?
  16. Value Investing
  17. Cheap Stocks
  18. What is a Financial Statement?
  19. Analyzing Financial Statements
  20. Stock Market Tip - Red Flags to Look For When Investing?
  21. The Annual Report – How to Read
  22. Stock Market Analysts – Stock Market Advice and Tips

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