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Investors: Analyze Financial Statements with a Critical Eye

Look For These Red Flags:

In late 2001 and early 2002, following the collapse of Enron and other companies such as Global Crossing, the entire accounting profession came under scrutiny. The public for the first time on a massive scale learned that there was a lot of "wiggle" room in accounting practices. As mentioned earlier in this lesson financial reporting is ruled by something called Generally Accepted Accounting Principles (GAAP). These are not accounting "laws" but rather suggestions of how to present data formulated by a committee called the Financial Accounting Standards Board (FASB). Because GAAP attempts to cover such a broad field,  it is filled with loopholes and allows for multiple ways of presenting the same data - in a perfectly legal manner. Thus, we have a system that gives corporate executives both the ability and the temptation to "manage" the financial statements in a manner which is advantageous to their compensation plans but not to individual shareholders. So, until stricter accounting rules are put in place, we, the individual investor, must cast a critical eye on all financial statements and utilize all of the information at our disposal. Following are just a few tips to assist you in trying to level the playing field:

(Note: To find the financial statements for a company we recommend using the site at Simply type in the symbol for the company you are investigating in the "Get Quote" Box and in the left column of the resulting page click SEC Filings. On the page that comes up you will see a list of documents the company has filed with the SEC. Typically you will chose the latest 10K which is the annual report that contains the 4 financial statements required by the SEC. Also here you can find Proxy Statements. Management Discussion and Financial Footnotes that are found within the 10K and 10Q [Quarterly] filings. If you want to compare statements for multiple years click the various statements at the bottom of the left-hand menu under the title "Financials")

1. Avoid Companies With High Relative Debt. When analyzing a company's fundamentals look closely at debt levels which are found on the Balance Sheet. Examine the Quick Ratio, Current Ratio, Long Term Debt / Equity and Total Debt / Equity. Debt is a valid vehicle for expansion but servicing the debt can severely drain current operating resources. Look at debt in relationship to industry average. If the debt of the company you are evaluating is much higher than industry average, you have a major red flag. Nothing can start the death spiral for a company faster than it missing a debt interest payment and having its credit rating lowered.

2. Look For Balance Sheet "Surprises". Quite often an indication that a company is playing fast and loose with accounting decisions is exhibited in sudden and surprising changes found on its balance sheet. You should always scan balance sheet numbers for at least a three year period. Here are the red flags to look for: 1) Big upward change in Accounts Receivable. This could be an indication that the company has changed the way it recognizes revenue and could be padding its earnings with sales that are due for delivery in the future in order to increase current earnings. 2) Big upward change in the Inventory Account. This could indicate a change in the way the company values its inventory - and there are several legal ways to do this. Any mid-stream change in valuation method is cause for suspicion. 3) Big downward change in Reserve Account. This is a balance sheet liability that is set up for such normal business events as product returns and bad debt. This account is subject to manipulation and in desperate straights management can slash it to unreasonably optimistic levels. If you see any sudden change in these items or others, look to the footnotes (see item 4, below) for an explanation.

3. Pay Particular Attention To The Cash Flow Statement. Of the three major financial statements (Income Statement, Balance Sheet and Cash Flow) the Cash Flow Statement is the hardest for accountants or executives to "cook". This statement shows the change in the amount of cash a company holds from one year to the next. And this is very difficult to fake without making outright fraudulent statements. If the statement shows that cash flow from operations is lower than cash flow from investing, the company is most probably increasing its debt burden. This is a major red flag. Another red flag results when sales are increasing but positive cash flow is decreasing. You need to find out where the money is going. If you can't, don't buy the stock.

4. Read The Financial Statement Footnotes. Unlike just about everything else we read, where footnotes can be conveniently ignored, footnotes to financial statements are important items in stock analysis. In the footnotes you should be able to find detail on matters such as: 1) accounting policies used, 2) changes in accounting methods used, 3) imminent or pending litigation, 4) long-term purchase commitments, 5) stock options granted to executives, etc. Any of these items could raise a red flag. The footnotes are used by some companies as a convenient place to "bury" unpleasant information that they are required to disclose but hope the average reader won't read. Don't be the average reader. (Look for "footnotes" in the Table of Contents of the 10K or 10Q filings that you accessed on the Web site.)

5. Be Wary Of Acquisitions and Joint Ventures. Companies open up a lot of space to "cook the books" when they acquire other companies or set up joint ventures. These transactions provide enticing opportunities to move debt off of their balance sheets and onto those of their partners or subsidiaries. They also open up the potential for generating bogus revenue flows by, for example, lending money to their partners who use the money to buy product from the parent. One way of telling if a company is making aggressive use of partners is to look on the Income Statement for "Sales To Related Parties". If this is a significant number you have a red flag. Such sales can be reported as earnings without the company actually receiving any cash! 

6. Review Recent 8-K Filings. The SEC requires a company to file an 8-K when it experiences any material event or corporate change which is of importance to investors. The Form 8-k provides current information on material corporate events that occur between the required financial statement filing periods. Before investing in a stock check for recent 8-K filings. (You will find them in the list of filings accessed on the Money Central Web site drop down menu mentioned above.) 8-K's will show you such things as major acquisitions, divestitures and perhaps most foreboding, changes in auditors. Many times when a company changes auditors its because they won't play along with management "suggestions" of how the books should look.

7. Read The Management Discussion. While this isn't one of the "big three" financial statements, the SEC requires that companies include a Management Discussion and Analysis (MD&A) section in their financial filings. Here management is required to discuss specific issues related to the financial statements and to assess its current financial situation, its liquidity, and its planned capital expenditures for the next year. In recent years the SEC has been looking more closely at the MD&A section to make sure that companies are not being misleading. If the company is having significant problems in a specific area, here is where it should be discussed with candor, not with a sugar coating. You can find Management Discussions as a part of the 10k and 10Q filings. Look in the Table of Contents of the filing.

8. Read The Proxy Statement. Proxy statements are not part of the standard financial report. As a diligent investor, however, you should read them. Proxy statements are reports that go to shareholders in which they solicit the authority to cast your vote for issues that require stockholder approval. Most people ignore them but you shouldn't. Proxy statements can include such interesting items as compensation packages for officers and directors. They also can show special "perks" for company executives. Here you can get a feel for the reasonableness of corporate compensation and if these plans seem to reasonable. An over-abundance of stock options in a compensation plan may be a sign that short-term stock price increase is rewarded more heavily than long-term corporate performance. Proxies will also show such events as lawsuits and other contingent obligations. We found proxy statements for companies on the Web at Enter the symbol of your company of interest in the Search box at the top right of the page and on the resulting page click SEC filings from the horizontal menu above the price quote. Then click the "Proxy" menu item below the quote or simply look in the list of filings for the most recent.  

9. Ignore Pro Forma Financial Statements. Periodically companies will announce "pro forma" earnings. They do this more for publicity reasons than anything else. These are NOT the statements or the numbers required by the SEC. Pro Forma statements have been described as "results before bad things are deducted". Ignore them.

10. Make Sure You Understand The Company Business. This may sound simple but it is crucial and a surprising number of people ignore this advice. If you can't understand how a company makes money after reading the annual report and examining the financial statements - don't buy it. Period. (Note that you can see a Company Report on the MSN Money site referenced above.)


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