One big lesson I've taken from investing is to be critical of the picture that gets painted by a company when it reports its results.
Life is full on, so it is easy to be lazy and accept a company's own biased narrative. But if we want to protect our hard earned money, our future wealth, that's not good enough.
We need to build our own critical view, because sometimes the pieces won't all fit.
Short sellers love to exploit these inconsistencies between a company's narrative and their own researched view of a company. We are watching this play out right now with sandalwood producer Quintis Ltd (ASX: QIN).
With earnings season not far away here are three red-flags to help you run a critical eye over a company's financial statements:
Red flag 1: Positive EBITDA, negative Operating Cash Flows
Management will pick out favourable numbers to present to investors, such as EBITDA – Earnings Before Interest, Taxes, Depreciation and Amortisation.
We need to quickly reconcile the EBITDA number against reported cash flow to make sure a company is actually generating cash. If a company is reporting positive EBITDA, we could reasonably expect to see that Cash from Operating activities, found on the Statement of Cash Flows, are also positive.
For example, for the half year to 31 December 2016 Telstra Corporation Ltd (ASX: TLS) reported EBITDA on the income statement of $5.1 billion and cash from operating activities of $3.2 billion. It would be a red flag if the company didn't have the cash to back it up.
Red flag 2: Accounts receivable growing faster than revenues
This is a surprisingly common red flag, often linked to the point above. If a company is manipulating numbers or reporting revenues before it has received the cash, there may be a spike in accounts receivable on the balance sheet.
If accounts receivable are growing faster than revenues over time, consider it a warning sign.
Red flag 3: "One-time" expenses that aren't one-time
Companies know that many investors skim over 'one-time' or 'non-recurring' costs on the income statement which makes it ideal for manipulation.
Slipping recurring operating costs into "one-time" expenses on the income statement can be used to bump up a company's operating margin and operating profit which investors are drawn to.
Have a look at past financial statements to check the 'non-recurring' costs are not, in fact, recurring. After a strong acquisition spree, I will be watching out for this with Vocus Group Ltd (ASX: VOC) going forward.
Foolish Takeaway
It is not difficult to scrutinise the pretty picture being painted by a company's management, and to form an independent view. If the pieces aren't adding up or don't feel right, be prepared to walk away.
