Tutorial: spot accounting red flags
Fraud is rare. Deterioration is common, and it shows up in the same places.
Run a ten-minute check that catches most of the disasters before they are news.
How spot accounting red flags works, in one picture
The same argument as the text, as a chain. Each step is what makes the next one possible.
The divergence that precedes most disasters
Reported profit climbing while the cash it supposedly generated goes nowhere. Either customers are not paying, or the sales were never really made.
- 1
Profit rising, cash not
The first and best check. If net income has climbed for three years and operating cash flow has not followed, the profit exists on paper and not in the bank. Everything else on this list is a variation of this one.
- 2
Receivables growing faster than sales
It means the company is booking revenue from customers who have not paid. Sometimes that is growth. Sustained, it means the company is selling to people who cannot afford it, or recognising sales that have not really happened.
- 3
Inventory growing faster than sales
Goods are being made that are not being sold. The write-down is coming, it is just not here yet.
- 4
Adjusted profit that is always adjusted
One-off charges every year are not one-off. If a company has taken a restructuring charge in each of the last five years, restructuring is what the company does, and the 'adjusted' number is fiction.
- 5
A balance sheet made mostly of goodwill
It is a record of expensive shopping. Goodwill is never depreciated; it sits there until the day management admits the acquisitions were worth less than they paid, and the equity halves in an afternoon.
- 6
Insiders selling in a cluster
Individual insider sales mean little; people buy houses. Several officers selling at once, after a run, is one of the few signals where the people acting know more than you and are legally obliged to tell you they did it.
Insider buying is the informative direction. Selling has a hundred innocent explanations. Buying has one.
You have run all six checks on a company you own and know which, if any, it fails.
Read next
Fraud is rare. Deterioration is common, and it shows up in the same places.
Moat scores for 1,100+ companies, with the returns on capital that either back the score up or quietly contradict it.