Detecting Red. Flags in a Company. By Gregory Ang, Research Analyst 1/12/2013. NUS Students Investment Society NATIONAL UNIVERSITY OF SINGAPORE

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1 Detecting Red 1/12/2013 Flags in a Company By Gregory Ang, Research Analyst NUS Students Investment Society NATIONAL UNIVERSITY OF SINGAPORE

2 Introduction Analyzing a company can be misleading. Easy as it is to screen out the underperformers with their negative profits and dismal cash flows in their financial statements, one might often end up with a list of companies with equally stellar credentials. After all, the point of these statements is to report the best side of the companies results, along with some sugar-coating along the way to attract new investors and keep existing ones. This may be especially prevalent in a sector going through an economic boom, where many companies experience increased growth due to sheer product demand alone, and not their inherent competencies. So how would one sift through the promising double-digit profit margins and impressive ratios? The answer is to dig deeper and find red flags, indicators of an unpromising outlook. This article details a few simple methods you can use to evaluate if a company s financial outlook is all that it s cracked up to be. You will be able to understand if a certain promising year is sustainable and realistic, or just a lucky break that is being inflated by the company. Sales Growth Trends The sales growth of a company can be easily derived, which also means that they can be easily taken for granted. After all, as long as a company posts higher revenue sales year by year, it looks good to investors. However, slowing sales growth, while positive, can precede a disappointing quarter and drive down a stock s price. Thus, predicting a possible break in the trend can save you substantial losses. An example can be derived from Noble Group. Figure 1.1 tabulates its quarterly revenue figures from 2009: Quarter March June September December Full Year Figure 1.1 Quarterly Sales Revenues of Noble Group (in USD millions) As Figure 1.1 show, Noble Group seems to be doing well for itself. It has constantly posted positive sales growth, with the exception of 1Q13.

3 However, this buck in the trend could have already been predicted if one were to compute the year-onyear sales growth in percentage, as Figure 1.2 shows: Quarter March - 88% 76% 14% -1% June - 80% 52% 23% 5% September - 79% 40% 9% December - 82% 15% 21% Full Year - 82% 42% 16% End-June Stock Price $1.18 $1.71 $1.97 $1.15 $0.97 Figure 1.2 Quarterly Sales Revenue Percentage Growth for Noble Group From Figure 1.2, we can see that Noble Group s stock price climbed from June 09 to June 11, notably peaking at $2.38 in Jan 11. While sales growth was already dropping, it was still healthy at well above 75% year-on-year. However, upon the 31.6% drop in growth percentage (76% -> 52%) in June 11, Noble Group s stock price has maintained a general downtrend up until present day, accompanied by comparatively dismal sales growth rates. For more in-depth analysis, this same principle can be applied to other figures, such as earnings growth, earnings-per-share and sales forecasts. Do note that the method demonstrated is not exhaustive in determining the trend of a company s stock price, but is a helpful way to know if the future of a company merits further investigation. Slowed revenue growth could be due to one-off expenses or events. Similarly, a boom in sales is unlikely to last long-term. These factors must be considered in order to get a clearer picture of the company. Inventory Levels The inventory levels of a company reflect on its sales. This is done by calculating the formula for gross profit: Gross Profit = Sales Revenue Cost of Sales Incidentally, the cost of sales can be calculated as: Cost of Sales = Beginning Inventory Ending Inventory Thus, if the ending inventory is higher, the cost of sales is lower, making the gross profit seem higher than it actually is. Logically, the ending inventory should decrease proportionately to increasing sales. However, if the company is producing more goods than the customers are buying, the ending inventory will be larger, and reflect in slowed sales growth in the next quarter. An example can be seen from Blackberry, as shown below:

4 1Q May Sales ($USD millions) [% growth] 4,235 4,908 [+15.9%] 2,814 [-42.7%] Inventory ($USD millions) Inventory as % of Sales 13.1% 19.2% 27.8% Figure 3.1 August Quarterly Sales and Inventory of BlackBerry Ltd As Figure 3.1 shows, BlackBerry s sales growth was healthy at 15.9% in May However, its financial statements reflected a 46.5% jump (13.1 ->19.2%) in inventory as a percentage of sales, a red flag signifying that demand was looking to slow down. Sure enough, in September 2011, BlackBerry announced a layoff of over 2,000 employees as a result of slowing company growth, and ended up contracting its sales by 42.7% in Its stock price from May 2011 to 2012 also dived from $42.85 to $ Companies with slowing sales growth may not always be heading into financial ruin. The supply and/or demand for their products may be affected by larger macroeconomic factors, despite the company being fundamentally sound. In that case, a well-managed company would predict the slowed demand and produce at a level which maintains a stable level of inventory. Despite BlackBerry s 15.9% sales growth, its proportionately higher inventory level indicated that consumer demand was underperforming its expectations, and its growth would not last. This same principle can also be applied to accounts receivable. If a company reports a spike in its receivables level, it could be because it is offering more favourable financing terms to its creditors in order to meet their sales targets. In the worst case, the company could be engaged in channel stuffing, an illegal activity in which more products are shipped and charged to buyers as accounts receivable, artificially inflating sales. These goods are usually sent back to the company, do not actually contribute to real income, and reflect a shrinking demand. Statement of Cash Flows The Statement of Cash Flows (SoCF) details the transference of cash in and out of the company, as opposed to measuring revenue that is earned on credit or assets in the income statement and balance sheet. As such, the cash flow paints a more realistic picture of the company s financial situation. In order to detect a red flag, we can use a company s Operating Cash Flow (OCF), which is defined as the cash generated by the company s basic operations. OCF determines whether a company s operations are sustainable. Some companies may report positive earnings while in fact, they have lost real cash. This could be due to them providing favourable payment terms to creditors, or burning through cash in order to sustain their sales revenue. In fact, creative accountants might manipulate figures and transfers in order to record positive earnings. That is why it is important to compare a company s OCF to its profit/income before taxes. Both of these figures can be taken from the SoCF. This trend can be seen in Healthway Medical Corp Ltd (Healthway):

5 Year ended 31 December Income before taxes (S$ '000) 11,817 17,737 3,274 Operating Cash Flow (S$ '000) 19,892 15,482-2,203 Net Income as % of OCF 59.4% 114.6% N/A Figure 4.1 Net Income and OCF of Healthway Medical Corp Ltd As Figure 4.1 shows, in spite of a 50% (11,817 -> 17,737) growth in income before taxes from 2008 to 2009, Healthway experienced a 22% drop in OCF (19,892 -> 15,482). Eventually, its earnings took a large dip in 2010, and its share price tumbled from 15.4 cents (June 10) to 6.2 cents (June 11). By right, a company s OCF should be increasing with its earnings. An increase in income but decrease in OCF signifies that the company may be using other means to pad its earnings reports, either through inflated accounts receivable or inventory levels. Also, the company could be engaging in heavier debt in order to finance its sales growth. Either way, the lack of actual cash coming in indicates that the current level of earnings is likely to be less than legitimate, i.e. stemming from actual business. Other Red Flags Debt While not touched on heavily in this article, a company s debt should not be discounted in a financial analysis. As mentioned above, a company s growth could be fueled by its heavy debt, which will not sustain long-term profitability. While it is definitely not a stark indicator of financial ruin, a company s debt should at least proportionate, if not much less than its growth. Therefore, you can use certain financial ratios to determine the quality of a company s debt level, such as the current ratio ( Current Assets/Current Liabilities) and debt-equity ratio (Total Liabilities / Shareholders Equity). Capital Expenditures A company s tangible assets, such as equipment and buildings, are always subject to yearly depreciation as they deteriorate over time. In order to maintain its operational capability, the company should be actively spending on capital expenditure, which goes towards acquiring or upgrading its tangible assets. This can be analysed by comparing two values found in the SoCF: the depreciation charge (found in Cash used in Operating Activities) and any forms of capital expenditure (found in Cash used in Investin g Activities), such as the purchase/upgrade of property and equipment. Ideally, capital expenditure should exceed, if not equal, depreciation charge. This is more of a yellow flag than a red one, but it still reflects whether the company is constantly upgrading the quality of its business activity.

6 Conclusion Finding red flags in a company can be difficult, as most companies may bury them in complicated financial statements. Also, the methods in this article are not exhaustive, and there are other ways to detect a red flag. As such, when analyzing a lucrative company, you can consider the following basic factors: 1) Growth: Is the company growing at an abnormally fast rate? Is it due to an overall economic trend, or something that the company is doing right? (Check the company s growth strategy, and decide on its economic feasibility) 2) Earnings: Are the earnings and revenue growing at the same rate? Could the earnings be due to a one-off payment? (e.g. debtor s repayments) 3) Debt: Is the company s debt level manageable? Is the risk taken resulting in positive returns? A helpful tool at this juncture would be the Notes to the Financial Statements section. Most figures stated in a company s financial statements are likely tagged to a numbered section in the notes, and will be explained in further detail. Thus, if you spot an abnormal figure, do not simply take it at face value. Look for the company s explanation, and evaluate the quality of that explanation before coming to any conclusions. Imagine yourself as a detective, looking for all the clues that show what really happened in a case. You ll be on your way to making more informed decisions, and looking for red flags of your own. research@nusinvest.com if you have any questions! We will do our best to answer your queries! This research material has been prepared by NUS Invest. NUS Invest specifically prohibits the redistribution of this material in whole or in part without the written permission of NUS Invest. The research officer(s) primarily responsible for the content of this research material, in whole or in part, certifies that their views are accurately expressed and they will not receive direct or indirect compensation in exchange for expressing specific recommendations or views in this research material. Whilst we have taken all reasonable care to ensure that the information contained in this publication is not untrue or misleading at the time of publication, we cannot guarantee its accuracy or completeness, and you should not act on it without first independently verifying its contents. Any opinion or estimate contained in this report is subject to change without notice. We have not given any consideration to and we have not made any investigation of the investment objectives, financial situation or particular needs of the recipient or any class of persons, and accordingly, no warranty whatsoever is given and no liability whatsoever is accepted for any loss arising whether directly or indirectly as a result of the recipient or any class of persons acting on such information or opinion or estimate. You may wish to seek advice from a financial adviser regarding the suitability of the securities mentioned herein, taking into consideration your investment objectives, financial situation or particular needs, before making a commitment to invest in the securities. This report is published solely for information purposes, it does not constitute an advertisement and is not to be construed as a solicitation or an offer to buy or sell any securities or related financial instruments. No representation or warranty, either expressed or implied, is provided in relation to the accuracy, completeness or reliability of the information contained herein. The research material should not be regarded by recipients as a substitute for the exercise of their own judgement. Any opinions expressed in this research material are subject to change without notice NUS Invest

FOREX Risk & Money Management. By Low Jie Ji, Research Analyst 1/12/2013. NUS Students Investment Society NATIONAL UNIVERSITY OF SINGAPORE

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