Eleven red flags in a set of accounts

Companies rarely fail without warning. The warnings are usually sitting in the accounts, in plain sight, quarters or years before they reach the share price. Here is what to look for, roughly in order of how loudly each one should make you stop.

The cash flow flags

• 1. Profit rises, cash does not. The loudest signal in accounting. Earnings are being booked that have not been collected. Sustained for more than a year or two, this precedes a very high share of blow-ups.
• 2. Receivables growing faster than revenue. The company is shipping product and being paid later, or not at all. Frequently means it is stuffing the channel to hit a number.
• 3. Inventory growing faster than revenue. Nobody is buying what they made. A write-down is queuing up.

The balance sheet flags

• 4. Debt rising while operating cash flow is flat. The business is being kept alive by lenders rather than customers.
• 5. Goodwill approaching or exceeding equity. The company has paid enormous premiums for acquisitions. One impairment can erase the entire equity base.
• 6. Constant share issuance. Your slice of the pizza is quietly shrinking every year. Check the diluted share count over five years, not the price.

The behavioural flags

• 7. The auditor resigns, or is changed. Rarely for boring reasons. Always find out why.
• 8. The CFO leaves abruptly. The person closest to the numbers has decided not to be near them any more.
• 9. Heavy insider selling into strength. The people who know most are reducing their exposure while telling you to increase yours.
• 10. The accounts get harder to read. New adjusted metrics, more footnotes, a longer "non-recurring" list every year. Complexity is often camouflage.
• 11. Adjusted earnings drift ever further from reported. When "one-off" charges recur annually, they are not one-off. They are the cost of doing business, being hidden.

Fraud is rare. Deterioration is common. Both leave the same fingerprints in the cash flow statement, and both should send you looking for the exit.