Watch out for Financial Shenanigans

In any market environment, it is important to understand the risks and the potential downside associated with a particular security. When the market moves higher for a sustained period, such risks increase. Under these conditions, it is more important than ever to review financial statements with a watchful eye.

In 2013, the stock market’s growth rate sharply exceeded the pace at which corporate earnings and revenues grew. Additionally, economic growth as measured by GDP was also less than robust – GDP increased only 2.1% in 2013, well below the long-term average of 3.3%. As a result, the increase in the price investors are willing to pay per each share of corporate earnings has been a primary driver of higher stock prices. In other words, valuation measures such as Price-to-Earnings ratios (P/E) have expanded.

In a low-growth environment, for the majority of companies, it is much more difficult to grow earnings per share or expand profit margins at high rates. In addition, investor expectations are raised and a disappointing earnings report can impact a stock’s price more dramatically. This increases the pressure on corporate management teams to deliver strong results. Under such circumstances, there is a greater likelihood that “creative” accounting may be deployed to make results appear better than they actually are.

When evaluating companies, it is important to review their financial statements with a wary eye. One example of how companies can artificially boost earnings is recognizing revenue before it is actually earned. A well-known example of a company recognizing revenue prematurely was Sunbeam when “Chainsaw” Al Dunlap was its CEO. Under Mr. Dunlap’s leadership, Sunbeam used nonexistent sales to boost revenues. Ultimately, these actions led Sunbeam to declare bankruptcy.

If you are not an accountant, the easiest way to identify possible risks is to compare the income statement with the cash flow statement. In particular, the first section of the cash flow statement measures cash flow from operations (CFO), which represents the actual amount of cash generated by the company’s operations before it makes investments such as purchasing new equipment, paying down debt or distributing cash to shareholders. As a general rule, there are two things to look for:

(1)    Is CFO greater than net income; and

(2)    If a company’s earnings are growing, its CFO should be increasing as well.

If earnings are growing and CFO is not, there is reason to be concerned. Such a finding does not necessarily mean that the financial statements are fraudulent, but it does give cause for concern. More thorough examination is necessary to try and determine why this is happening.

When BWFA analyzes companies for inclusion in client portfolios, reviewing the cash flow statement is an important part of our analysis. The cash flow statement serves as a bridge between the income statement and balance sheet, as it starts with net income and then incorporates changes in the company’s assets and liabilities.

BWFA has specific sell criteria that are consistently applied. One of these criteria requires us to sell a stock if we identify reasons to be concerned about its accounting. If such issues are identified when analyzing a stock for potential inclusion in client portfolios, we will not purchase it. In our view, accounting-related concerns increase risk. We work diligently to keep client assets from being exposed to such risks.