By Cassie McLean
Learning the implications of a just a few corporate decisions may be all it takes to foresee distress within a struggling company, said Mark Tatge, former senior editor at Forbes magazine and a distinguished visiting professor at DePauw University.
Tatge spoke at Saturday’s Society of American Business Business Editors and Writers‘ conference in Indianapolis, detailing a concise list of 10 red flags that should cause all privy business reporters suspicion.
1. Deferring expenses: Companies are supposed to match income with corresponding expenses. Reporters should expect that in the period where the revenue is recorded, the expense to create that revenue should also be recorded. The effect of amortization over time means the current company’s profits will be inflated.
2. Pro-forma earnings: Companies that plan to merge or divest often come up with “pro-forma” earnings, an estimate of what the firm will be after the merger. However, the number is often based on inaccurate assumptions. For example, management may include or remove net income that it feels is not “material” to the remaining company.
3. Firing auditors: Often this occurs due to a disagreement over accounting standards and the discrepancy can clue reporters into bigger issues.
4. Burying exhibits: Companies often bury important documents through several levels of reports dating back numerous quarters, or worse, years. To find such items, reporters may have dig through many levels of 8Ks.
5. Fudging inventory: Keep an eye on how companies report the value of inventory, found on the balance sheet, either through FIFO (First In-First Out) or LIFO (Last In-First Out). Companies are required to pick a method and should not switch. Doing so, particularly switching to FIFO in times of rising costs, can produce higher profits.
6. Stock buybacks: Beware. While the immediate impression is that the company is confident in its future prospects, a good reporter must ultimately ask, “Should they be doing something different with their cash?” Additionally, buyback artificially improves earnings per share.
7. Shell games: Companies are forced to set aside funds to cover defaults, decreases in asset values or inventory obsolescence. This pot of money, called asset reserve, is expensed and reduces net income. Thus, if a company has set aside too much, it can recapture reserves, boosting profits and lessening expenses for a given quarter.
8. Pay attention to cash: Look at how much they’re generating versus spending and whether the company has enough to cover current liabilities. Subtract current liabilities from current assets to find out the company’s working capital, how much in liquid assets the company has to pay its debts in the future.
9. Understanding liabilities: Companies will understate liabilities to inflate current earnings. Look for costly contracts or contingencies, like merger breakup fees, pending lawsuits or contractual arrangements with vendors.
10. Blowing deadlines: If a company misses a 10Q or 10K filing, it’s an immediate red flag. Suspect bankruptcy or liquidation, a large charge against earnings, re-valuation of assets or the business itself, or restatement of past financial results.
The challenge, however, is that no one item will get you further than another.
Often, Tatge said, it’s about being a careful reader of financial statements, drawing comparisons and remembering the hackneyed idiom: If it looks too good to be true—it probably is.
McLean is a UNC-Chapel Hill journalism student attending the SABEW conference.
