I introduce five items to take note of, in the process of checking for possible accounting shenanigans.
A large amount of cash with extremely low deposit rates is a major warning sign. If the company’s cash yield is significantly lower than bank deposit rates and government bond yields, it could indicate a possibility of fraud or embezzlement. Other warning signs of possible fake cash at cash-rich firms include low dividend payout and high levels of debt.
Companies with gross margins and operating margins that are much higher than those of their peers are possibly overstating earnings. If things are too good to be true, they are most probably not true. If a company in a cyclical, low-margin, highly competitive industry exhibits consistently higher margins without reason, I would be very skeptical.
A company with good working capital management will take payments up front in cash from customers and pay suppliers as late as possible. Such a company will have the shortest cash conversion cycle. A long cash conversion cycle of more than 90 days is a sign of uncollectible accounts receivables, obsolete inventories or worse still, bogus receivables and inventories.
Companies in asset-intensive industries which require the heavy usage of machines, machinery and other equipment, will generally need to use a significant portion of their cash flow every year to service and maintain old equipment and buy new advanced equipment to keep up with the pace of technological change in the industry. Higher capex for the same production capacity could also suggest misclassification of operating expenditure as capital expenditures a la WorldCom.
While most investors focus their attention on the profit and loss statement and earnings, it is ultimately the cash that counts. Net income and operating cash flow may diverge in any one year or financial period because of accrual accounting: the recognition of earnings may vary from the actual cash inflows and cash outflows. However, a prolonged divergence (three years or more) between net income and operating cash flow could be something worthy of concern.