When we invest directly in companies, other than looking at valuations, we also need to determine the financial health of the company. Even cheap companies may be bad investments if they are facing financial problems. However, many companies will find ways to sugarcoat their financial statements by a common practice known as earnings manipulation. So investors may be falsely led to believe the company is doing well until it is too late.
Enron is a very famous case in the US of one of the largest oil & gas firm in the US which went bankrupt, affecting tons of investors and their employees as well.
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So how do we figure out which firms have financial issues? We will discuss 2 primary methods you can use to study financial statements.
1. Follow The Cash
Follow the cash is basically to track the cash flow instead of focusing on earnings. Earnings are easily manipulated by accrual accounting such as early recognition of revenue, misstating of expenses etc., operating cash flow is a more persistent measure of company performance. As a rule of thumb, there should be a consistent relationship between net income and operating cash flow. So increasing net incomes should be accompanied by increasing operating cash flow. In layman terms, a company which is making money should see its bank account increase in value right (Not taking into effect investments or financial borrowings)?
For example, Enron was one such entity which consistently reported increasing earnings despite decreasing operating cash flows.
2. Increasing Accounts Receivables and Days Sales Outstanding (DSO)
Increasing receivables allow the firm to book sales without actually showing the cash inflow. The firm will basically have to inflate trade receivables to overstate revenue. In some cases, the debtors were actually related parties. Another item to look at is Days Sales Outstanding (DSO) – which is basically the number of days taken to collect the money owed by customers.
DSO = Accounts Receivable / Sales x Number of Days
The longer it takes to collect the receivables, the more likely the customer may default, turning into bad debts. Therefore the longer the days receivables, the lower the quality of the revenue and it also reflects poorly on the credit policies of the firm.