When analyzing financial statements, you may need to assess whether they are wrong. You may need to assess whether they indicate undisclosed problems, as well. Some comfort may be gained by the situation, and perhaps some corroborative information, such as:
- Does the company use an outside CPA, and if so, what services does the CPA provide?
- Does the CPA prepare audited or reviewed financial statements?
- Does the accountant review bank activity and reconciliations?
- Are journal entries being properly recorded in the company’s books?
Common Indicators of Problems
Below are some red flag indicators that there may be problems with a company’s financial statements.
- Cash has a negative balance. This could be due to the company having credit facilities available, but could also be caused by the company’s failure to reconcile bank statements to the general ledger. In many instances, a company will record cash disbursements (checks written), but fails to record all deposits. Such an occurrence tends to understate revenues and profitability. This could also indicate an overstatement of receivables.
- Book inventory is not reconciled to physical count inventory. In many businesses, inventory is one of the largest assets for the company. Failure to do a physical count, and book any differences, may result in a material misstatement of inventory. Without doing such a reconciliation, problems such as theft and other causes of inventory shrinkage may not be discovered. Further, inventory balances (on the balance sheet) impacts cost of goods sold (on the income statement). If actual ending inventory is $100,000 less than what is reflected on the books, the income statement may be overstating gross profit by $100,000, as cost of goods sold is understated by $100,000.
- Not understanding inventory methodology. Assuming the cost of purchasing inventory is increasing over time (i.e. vendor prices are increasing), FIFO (first in first out) will provide a more accurate indication of the current replacement value for ending inventory, but it will result in a lower cost of goods sold and higher gross profit. LIFO (last in first out) will cause a lower ending inventory and a higher cost of goods sold. A company that regularly changes its inventory methodology, could be manipulating earnings.
- Sales growth without cash flow growth. As sales grow, there typically is a corresponding growth in cash flow. There should be a general correlation between the two over time. Rapid sales growth without an increase in cash flow, could be an indicator of fictitious sales, or noncollectable receivables.
- Inventory and accounts receivable outpacing sales. Like #4 above, as sales grow, one would generally expect inventory and accounts receivable to grow. In general, larger inventory quantities are needed to meet the demands from increased sales. Also, higher sales typically cause the accounts receivable balance to be higher, as well. If inventory or accounts receivable is growing at a faster pace than sales (or perhaps inventory or accounts receivable is increasing while sales are falling), the company could have obsolete inventory, noncollectable receivables, an inefficient collection department and procedures and may be heading in a bad direction. This could also be an indicator of inflated assets on the balance sheet and/or inflated revenues on the income statement.
- Large “other” or “miscellaneous” items on balance sheet or income statement. Usually these captions consist of small items that are grouped together for financial reporting purposes, as they are not easily classified elsewhere. If the balances in these accounts are material to the financial statements, you should seek more information as to the contents, as management might be trying to hide the detail.
- Debt to equity ratio is rising, indicating that the business is becoming more and more reliant on debt financing to run operations instead of from equity and operating profits. The company could become financially distressed with an economic downturn or change in interest rates.
- Revenues trending downward might be an indication that the company is contracting, losing market share or not keeping pace with their industry, thus without a “game plan” the future of the company could be uncertain.
- Gross profit margin is decreasing on consistent sales, indicating that the business’ cost to produce its product or service could be increasing. Unless the company can address these costs and reduce direct operating expenses, it may struggle as an ongoing business.
Evaluating and interpreting financial statements is just one of the many fraud detection services that we provide. Investors, lenders, vendors, and others rely on the accuracy of financial information when making decisions regarding an entity. Accordingly, having reliable and transparent financial information is essential to the user to allow them to make the best and most appropriate financial decision.