How to Identify Red Flags and Avoid Bad Investments

how to identify red flags and avoid bad investments in investing

The investing world has always been obsessed about finding the next big thing to invest. Unfortunately, not enough attention is paid on how to identify red flags and avoid bad investments. In this article, we go through our process of spotting and identifying red flags in companies. To do this, we thoroughly analysed past and present accounting scandals and put together what we think are the red flags in investing that not only can potentially predict imminent profit warning, but also sniff out possible fraudulent company practices.

“If it is too good to be true… it is probably a fraud.” –Ron Weber

We have broken down our analysis into three parts: financial ratios, pro forma financials and common sense checks.

Before we jump in, here’s a quick refresher of the three key financial statements which we will talk about throughout this article.

  • Balance sheet/Statement of financial position: Tells you what you own and owe at a particular date.
  • Profit and loss / Income statement: Tells you how much you are making/losing over a time period.
  • Cash flow statement: Reconciling the actual cash at hand over a time period.

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Table of Contents
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    How to avoid bad investments 101: Financial ratios

    Here are the key ratios that must be in every investors’ toolkit. These are applicable to all type of companies in general, except for Financials, due to its complicated business model.

    Debtor/Sales or Accounts Receivable/Sales ratio

    This measures how much you are owed for the products/services you have delivered. Usually expressed as percentages/days, a growing debtor/sales ratio can imply that the company is increasingly cash-strapped.

    To calculate this ratio, simply look for “Accounts receivable” under “Current assets” in the balance sheet, and divide it by its “Total revenue” of the corresponding year. The table below shows how Carillion’s debtor/sales ratio increased steadily since 2010 before its demise in 2018.

    Did you know?

    Carillion plc was a UK construction/facilities management services company. Cash flow issues and delay in payments subsequently lead to its liquidation in 2018.

    Carillion debtor sales ratio
    Source: Company report and Bloomberg.

    Quality of debtors

    Often times, debtors/sales ratio may not depict an accurate picture. This is where analysing the quality of debtors come in handy. Looking at the figure below, notice how over the years, trade receivables remain fairly stable, while amount owed by customers continue to creep up. This suggests a deteriorating quality of debtors, given that its customers are increasingly delaying its payments.

    Carillion debtor composition
    Source: Company report and Bloomberg.

    Creditor/Cost of Sales or Accounts Payable/Cost of Sales ratio

    This represents the speed which a company pays its suppliers. Similar to debtors/sales ratio, this is usually expressed in percentages/days. The higher the ratio is, the slower a company is paying its suppliers. Readers will notice the need to balance these two ratios to preserve the cash at hand for a company.

    To calculate, simply look for “Account Payable” under “Current liabilities” in the balance, divided by the corresponding cost of sales. Here’s a table of Debenham’s relatively higher and gradual increase of its creditor/cost of sales ratio over the years before going out of business.

    Did you know?

    Debenhams is a British multinational retailer operating departmental stores in the UK and Denmark, with franchise in other countries. In April 2020, Debenhams entered administration (again) due to its inability to service its debt pile.

    debenham creditor cost of sales ratio
    Source: Company report and Bloomberg.

    Inventory/Sales ratio

    Finally, the inventory/sales ratio measures the efficiency in managing its goods. When a sale is made, inventory from the balance sheet are transferred to income statement as “cost of goods sold”. The problem usually arises when a company is unable to sell its goods and start building up inventory. Consequently, this will result in an increasing inventory/sales ratio, usually a negative pre-cursor for companies.

    Here’s a table of illustrating Folli Follie’s meteoric rise in its inventory/sales ratio.

    Did you know?

    Folli Follie is a Greek-based company that manufactures jewelry, watches and fashion accessories. The firm was eventually fined for overstating its revenue by >€1 billion. Its shares were subsequently suspended.

    Folli follie inventory sales ratio
    Source: Company report and Bloomberg.

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    Net income and cash flow conversion

    A key question investors should always ask is how much “cash” is actually being generated from its “profits”. At least in accounting, “profit” doesn’t always equal to “cash” generated. Generally, profits includes non-cash items that could distort the actual story.

    One way to go around this is to identify its free cash flow conversion. In simple words, it measures how much “profits” are actually “cash” generated, usually expressed in percentages. Using Folli Follie as an example here, notice that despite 5-year cumulative net income steadily rising, free cash flow conversion dipped to close to 0%. Questionable net income figures?

    Folli follie fcf conversion
    Source: Company report and Bloomberg.

    Pro forma financials

    Made popular by arguably one of the most famous short-seller, Jim Chanos, pro forma is the Latin term for “for the sake of form”. Pro forma financials are statements that excludes one-offs, unusual or non-recurring transactions.

    Here are just a handful of “interesting” examples

    • Recurring non-recurring costs (speechless): Basically saying it’s a perpetual cost, but we’re going to exclude it because its non-recurring nature. [Anonymous insurance company]
    • Community Adjusted EBITDA (what?): EBITDA but excludes rent, tenancy expenses, salaries of building etc. [WeWork]
    • EBITDAC (jokes): EBITDA before the impact of coronavirus. [Every companies’ dream in 2020]

    The following are a few accounting "tricks" that have been used in the past.

    Capitalising (delaying) expenses

    Perhaps, one of the most common practices by some firms is the improper capitalisation of costs. This has the impact of artificially make a company appear financially healthier today. In particular, costs that are incurred today are capitalised as an asset, leading to an overstatement of assets and under reporting of expenses. In simple terms, this is pushing expenses recognition into the future.

    The WorldCom scandal in 2002 highlighted the potential fraud on a huge scale with some creativity in accounting. Consequently, WorldCom was forced to admit it inflated assets by $11 billion with another $3.8 billion in expenses that was improperly booked as capital expenditure.

    Frequent restatements

    Frequent restatements is another common signal of possible signal of improper accounting. These usually happen either by a change in accounting principles or to correct previously disclosed errors. It goes without saying that restatements are usually negative, ie either lower profit or higher cost. Oddly enough, we can’t remember the last time we saw a restatement that was positive.

    Interestingly, because restatements are backwards looking, they have tended to escape the eyes of investors. This could be one of the reason why accounting scandals relating to this issue can take a long time before being uncovered.

    As recent as 2019, Hertz, the car rental company who recently filed for Chapter 11, agreed to pay $16 million to settle fraud and other charges brought by the SEC, owing to multiple filings that contains inaccurate financial statements and disclosures.

    In particular, from Feb 2012 to March 2014, Hertz materially misstated its per-tax income. Subsequently, Hertz identified $235 million in previously reported pre-tax income was not consistent with its accounting principles in 2015.

    Aggressive acquisition strategy

    Companies who exhibit aggressive acquisitive behaviour must be probed in greater detail by investors. Historically, such behaviour are linked to companies who have something to hide. One of the ways is to inflate buying prices, so that the historic losses can be accounted for. More specifically, since goodwill is no longer amortised, companies have an incentive to allocate more of the purchase price to goodwill.

    In 2011, Olympus (famous for its interchangeable-lens cameras) did exactly that. Olympus’ string of odd acquisitions includes a mail order retailer of cosmetics and a company that produces health supplements from mushroom extract and a maker of microwaveable cookware.

    Yet, the market continue to give them the benefit of the doubt. In the end, a total of $1.5 billion of investment losses was uncovered, with some evening dating back to 1980s.

    Common sense checks

    An important but often missed part of most investment/research process is common sense checks. Your spreadsheet and model may be telling you that this is the best business in the world, but reality could be otherwise.

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    Industry read-across

    Does it make sense for a UK-only chain of café specialising in cakes to be more than twice as profitable as Starbucks? While we acknowledge, we may be comparing apples with oranges, the differences are too significant to ignore!

    Gross margin patisserie valerie comparables
    Gross margins of Patisserie Valerie and comparables. Source: Company report and Bloomberg.

    Eventually, Patisserie Valerie went into administration resulting from thousands of non-existent false sales entries. Overnight, this went from a ~£500m market cap company to being sold to a private equity for £5m.

    Auditors' fee

    Another interesting ratio raised by a famed short seller GCR is the auditors’ fee as a % to revenue. Here’s a table from the research report of Let’s Gowex’s auditors’ fee as a % to revenue relative to peers.

    Table of Gowex’s auditor fee as a % of revenue and comparables
    Source: GCR research.

    Founded in 1999, Let’s Gowex is a Spanish FinTech company that was supposedly making money by providing Wi-Fi in cities globally. When the fraud was uncovered in 2014, it was said that most of the contracts never existed. The founder and CEO is currently facing trial on fraudulent share price manipulation.

    Corporate governance

    In investing, a sound corporate governance is paramount. While this invites endless opinion on what an effective corporate governance means, here are just a few things we think investors should be aware of.

    • Possible auditor conflict. For example, auditors providing audit and consulting services concurrently should be avoided.
    • Independence between senior management team. Personal relationships between executives may lead to a less effective governance structure. For example, Let’s Gowex’s Head of Investor Relations is the CEO’s wife.
    • Experience and history of executive team. This, again, is often look through by most investors. Past history and current culture should be part of investors’ due diligence.
    • Related parties dealing. Often applicable to smaller growing companies, how companies award services contract may not be entire transparent. This could be contracts awarded to related parties (friends & family). For example, Metro Bank, a fast growing UK retail bank (used to be), has paid almost £24 million to a company owned by the Chairman’s wife, for its architectural and branding services, from 2011-2018.

    Management's incentives

    This comes back to what we’ve written about insider ownership. It can be argued that the likelihood of a company engaging in fraudulent activities is smaller, the larger the insider ownership is. It’s intuitive, but not fool proof.

    In addition, identifying how management team are incentivised is also key in avoiding bad investments. For example, annual reports usually discloses how key management personnel are compensated upon achieving a certain set of KPIs. A precipitous change in strategy is an invitation to investigate further.

    So far, we’ve highlighted the red flags to look out for to avoid bad investments. The points discussed should be taken into consideration as a whole, rather than in isolation. In our view, avoiding bad investments is as important, if not more, than finding a good investment.

    Lastly, the red flags in investing that we discussed are inclusive but not an exhaustive list. Leave us a comment if you think there’s something we missed. That's all for now!

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