Warning Signs To Look For In Annual Reports

freedigitalphotos.net/David Castillo Dominici

Warning Signs serve a very important role in our lives.  They caution is in advance about the imminent dangers if we do not follow the guidelines or rules. We come across warning signs everywhere and they provide the information through signs so you immediately recognize them and take appropriate precautions.  So, what does this have to do anything with investing?  Just like any other activity investing is also filled with lot of dangers for the reckless investor.
Corporate governance is still a big concern in India and it is found to be lacking in both small as well as large companies.
While looking for warning signs may not completely guarantee protection from bad managements, it does provide adequate safety.  Investing is all about avoiding mistakes and in investing an ounce of prevention is better than a pound of cure.
When we consider a stock for potential investment, we should investigate the company to look for any potential warning signs so you can avoid low quality businesses or businesses with questionable management quality.  Annual reports are a gold mine for those that are looking for warning signs.  Listed below are some of the warning signs that I have documented based on information from various books.  Financial Shenanigans by Howard Schilit is a great book for those who want to get more knowledge on this

Warning Sign	Probable Causes
Cash and Cash equivalent (investments) declines	Liquidity issues.  They may need to borrow
Receivable growth > Sales growth	Aggressive revenue recognition or granting extended credit terms to customers
Receivable growth < Sales Growth	If this is substantial, there is a possibility that the receivable has been reclassified as another asset category
Bad debt reserve decline relative to gross receivables	Under reserving to inflate operating profit
Unbilled receivables grow faster than sales or billed receivables	May be a greater portion of revenue is coming from percent of completion method
Inventory growth > Sales or COGS or Payables	Inventory may be obsolete or company has not recognized the cost of sales on some sales to push margins
Inventory reserves decline relative to inventory	Under reserving and inflating operating income
Other assets rise relative to total assets	May be capitalizing certain operating expenses
Gross Fixed assets increase as part of total assets	May be capitalizing repair and maintenance expenses
Gross fixed assets decline as part of total assets	May not be investing in new plant and equipment
Accumulating depreciation declines as gross fixed assets rises	Sign of slower depreciation to inflate operating income
Goodwill rises sharply relative to total assets	May be tangible assets are reclassified as goodwill to avoid expensing them in future periods
Accumulated amortization declines as goodwill rises	Failing to take sufficient amortization charge thereby inflating operating income
Account payable growth > revenue growth	Failed to pay off current debts for inventory and supplies which could lead to large cash outflow in future
Accrued expenses decline relative to total assets	Company might have released reserves inflating operating income
Deferred revenue decline while revenue increases	New business is slowing or reserves are release to inflate revenue
COGS grows rapidly than sales	Pricing pressure and inability to increase prices leading to lower margins
COGS sold declines relative to sales	Company might have failed to transfer entire cost of goods from inventory
Operating expenses declines sharply	Perhaps operating costs are being capitalized
Operating expense rise significantly	Inefficient operations spending more for each unit sold.  Company may be compromising margins for the sake of growth
Interest expense declines relative to long term debt	May be capitalizing interest cost
Operating Cash flow lags behind net profit substantially	Quality of earnings may be suspect or expense for working capital have been too high
Change in accounting principle, estimate or classification	Attempt to hide an operating problem
Auditor change (especially if they quit), debt rating downgrades or non-coverage, CFO changing overnight	Signs of people bailing out of problematic company
Long term commitments contracts or contingencies	Potentially large drain on cash reserves
Potential litigation/investigation	Drain in cash
Misguided management incentives	Can dress up numbers
Weak control environment with only insiders	Can dress up numbers
Concerns from auditor	Signs of risky company
Percentage of completion method	Revenue may be inflated
Bill and hold accounting	Revenue may be inflated
Financial problems at key customers	Revenue may be impacted
Seller finances customer	Revenue may be inflated and business is too weak and risky
Customer has right to return or reject the consignment	Revenue may be recorded too soon
Capitalized software or interest	Operating income may be inflated
Prepayment of future expenses	Would inflate operating income in future
Changing accounting policies	Unjustified. May be deliberate attempt to hide something.
Deferring expenses	Profits are overstated
Income smoothing	Profits are understated
Recognize revenue too soon	Profits are overstated
Under accruing expenses	Profits are overstated
Changing discretionary costs	Manipulating profits
Taking a big bath write off	Future profits are boosted