Financial statements show not only where a company stands financially, but also where it may be headed. Contractors who work with their financial advisors to analyze their statements can often catch problems early on before they turn into bigger issues.
The income statement is one of a company’s major financial statements, along with its balance sheet and statement of cash flows, and it can be manipulated in a few common ways. The income statement shows what a company’s earnings (or profits) are by showing all its revenues and expenses for a specific period. Income statement analysis is an integral aspect of fundamental analysis. The statement should capture an honest and accurate picture of a company’s financial situation so that investors can make informed decisions about buying or selling shares.
Because these numbers are so important, they must be reviewed and approved by an independent auditor. Unfortunately, auditors can be fooled by fabricated numbers or even turn a blind eye to such happenings. Here are a few red flags to watch out for:
Revenue Manipulation
Revenues are vulnerable to misrepresentation. Common ways to manipulate revenues include recording revenue before it is actually earned or even making up revenue that does not exist. Businesses can do this by making fraudulent sales to complicit related parties (for example by selling to a sister company with immediate plans to cancel the sale), recording sales that are incomplete because they are tied to some condition (for example, recording the full value of an installment sale), recognizing consignment as completed sales, and altering contracts to boost sales. A company could also delay acknowledging customer returns to a later quarter, or perhaps ignore them altogether.
High Number of “Other” Expenses
Many companies have “other” expenses that are very small or inconsistent. It is normal and is reflected in the balance sheet and income statements. However, when these items have high values, it is a definite red flag and needs to be checked. In many cases, some of these expenses can be reclassified. Other times, the high value may be a one-time occurrence.
Delving into your company’s financial statements will give great insight into its overall performance and future. Knowing the basic red flags will help you identify problems and solve them efficiently before they become major. In this manner, you will get a true sense of your business’s profitability, liquidity, and flow of cash.
Non-Operating Income
It always looks good when your company shows consistent income from continuing operations. Investors are often leery of seeing income from the sale of fixed assets, a large one-time sale, or the sale of investments. Operating income is listed separately from non-operating income on your income statement. If you notice a definite increase from year to year, it may be necessary to target sources of revenue that are solid and steady.
Inventory Manipulation
One common way of manipulating expenses is through inventory manipulation. For instance, a business could buy materials and then not record the full expense of the purchase or not record the purchase at all. Companies can also exaggerate vendor discounts to reduce costs or not write off inventory that is out of date and no longer saleable. Other schemes include over counting or undercounting inventory to present whatever picture management wants to paint or creating a phantom inventory
Several Years of Revenue Trending Down
If a company has three or more years of declining revenues, it is probably not a good investment. While cost-cutting measures—such as wasteful spending and reduction in headcount—can help to offset a revenue downturn, it probably won’t if the company has not rebounded in three years.
Final Thoughts
Both revenues and expenses are vulnerable to manipulation. Company management often has an incentive to engage in manipulation and auditors do not always catch on. Reading the income statement and management’s discussion of its business (together with the balance sheet and footnotes, as well as the cash flow statement) provides clues for vigilant investors.
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