Despite the accounting irregularities in some listed companies, investors can be forewarned by looking at the company’s liquidity, profitability, management, borrower communications, external environment and strategy.
Q: How can an individual investor without much financial training detect financial irregularities in listed companies?
Investors always depend on financial statements to make investment decisions. Following the recent accounting frauds in a few listed companies, some investors wonder whether they should still take the effort to analyse financial statements, given that those statements may not be true or reflect the real picture of the company.
Nevertheless, we believe financial statements still provide us with the main source of references. Besides, there are other indicators of the company, which can also provide us with certain levels of financial warnings.
According to Charles W. Mulford and Eugene E. Comiskey in their book titled Financial Warnings, there are mainly six types of financial warnings: liquidity, profitability, management, borrower communications, external environment and strategy.
Liquidity
One of the most important types of financial warnings is liquidity. This factor is normally related to the massive expansion of a company’s operation way beyond the control of the company’s management.
In most instances, the company’s internal control fails to provide adequate control on the company’s risk management. Besides, a company that shows a sharp increase in trade debtors or a jump in bank borrowings may imply it has liquidity problems.
Besides financial statements, there are other indicators of a company that can provide investors with certain levels of financial warnings.
Profitability
Retailers always have problems in determining the quality earnings of a company. Sometimes, the reported profits of a company may not reflect its real earnings, as a big portion of the profits were derived from non-operating sources of income, for example, the gain from the disposal of assets, securities or accounting adjustments for net income.
One of the key indicators in this section is gross profit margin as a percentage of sales. We should be checking if there is any deterioration in gross profit margin resulting from price cutting on key products.
Management
Good management will discuss the company’s performance and prospects during analysts’ briefings or in the annual reports.
However, some companies talk freely to investors when things are going well but “clam up” when troubles and disappointment occur.
Investors need to take note of the resignation of key management or change of owners, excessive perks for owners, lifestyle of owners not being consistent with the profitability of the company or the management’s projections of sales and earnings that are well beyond past history.
In Malaysia, we should be alert to events like the disposal of a significant equity interest by the major shareholders, failure to meet earnings projections or pending some material litigation.
Borrower communications
In this section, the two most important indicators are the delay in providing financial statements and changes in accountants or auditors.
We should also be watchful on the change in format of income statement, the change in financial year-end or the provision of only basic financial information without much detail on certain key important items.
External environment
A good management should be able to perform well during the good as well as bad times.
Investors need to be watchful for changes in external environments like the increase in interest rates, changes in regulations, new competition or new technologies in the industry.
Strategy
Financial warning on strategy mainly refers to the expansion into unrelated businesses or a fundamental change in business direction.
In Malaysia, some second board companies incurred high losses during 1997/98, which were mainly due to expansion into unrelated businesses like property development activities during 1996.
