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Financial Statements Forensics – Checking Cash Flows and Accruals

05.03.2012 · Posted in Dividend Stocks

I am writing this post in to highlight a recent article in the Edge Malaysia. It is an interesting look at financial fraud and how to spot it. Financial fraud has plagued public companies all over the world and Malaysia is no exception. Some of you may remember the big names such as Enron which saw many investors lose all their money as well as employees who lost their retirement benefits. So how can an ordinary investor protect him/herself? One of the ways is to conduct some DIY financial statements forensics.

 

Follow The Money

“Follow the money” is a simple term which refers to tracking the cash flow. The reason is simple, while earnings are easily manipulated by accrual accounting i.e. early recognition of revenue, misstating of expenses etc., operating cash flow is a more persistent measure of company performance.  As a rule of thumb, there should be a consistent relationship between net income and operating cash flow. So increasing net incomes should be accompanied by increasing operating cash flow. In layman terms, a company which is making money should see its bank account increase in value right (Not taking into effect investments or financial borrowings)?

For example, Enron was one such entity which consistently reported increasing earnings despite decreasing operating cash flows. In Malaysia Edge, Silver Bird was singled out for having negative net cash flow from operations from 2007 to 2009.

 

Increasing Accounts Receivables and Days Sales Outstanding (DSO)

Increasing receivables allow the firm to book sales without actually showing the cash inflow. The example stated was Transmile Group Bhd which inflated trade receivables to overstate revenue. In some cases, the debtors were actually related parties. Another item to look at is Days Sales Outstanding (DSO) – which is basically the number of days taken to collect the money owed by customers.

A rough calculation of  DSO = Accounts Receivable / Sales x Number of Days

The longer it takes to collect the receivables, the more likely the customer may default, turning into bad debts. Therefore the longer the days receivables, the lower the quality of the revenue and it also reflects poorly on the credit policies of the firm.

 

There are many other ways to check for earnings manipulations, however it would be too comprehensive to cover in one post. I may add more techniques later on. Stay tuned!

 

For further reading, you may be interested in:

Questions & Answers With Calvin Yeo On Stock Investments

My Singapore Stock Portfolio End March 2012

Comments on Straits Times Article Sin Stocks Are Good Buys

Basic Categories of Stocks and Identifying Them Correctly for Diversification Purposes Part 1

Equity Investments – Stock Switching Strategies

Understanding Malaysia REITs Part One – REIT Categories

 

8 Responses to “Financial Statements Forensics – Checking Cash Flows and Accruals”

  1. Raymond Lim says:

    Will you be divesting SMRT stocks. SMRT going to upgrade the railway by SGD$900M, for coming 8 years. May not have sufficient to pay dividends to shareholders and investors. Most of analyzts downgraded SMRTS to sell. Any comments Bro ?

  2. MoreMore says:

    Calvin, Thank you for the information. Your sharing is marvelous.
    Looking forward to your next writing.

    Now when looking at Annual report, need to see the receivable and the DSO. :)
    is it possible for you to provide the real example calculation ?
    How to know what is the fraud DSO number?

    thanks.
    MoreMore

    • Hi Moremore,

      There is no such thing as a DSO fraud number. However, a high DSO in relation to the industry in general is a signal of problems.

      For example, if we look at QAF Q1 numbers

      Sales = $240mil
      AR = $77.7 mil
      DSO = 77.7/240*91 = 29 days

      So 29 days is about average compared to the industry which is one month credit term. For most manufacturers, it is normal to see DSO between 15 days to 60 days. Any DSO in excess of 90 days may be considered excessive as the customers are generally taking more than 3 months to pay back the company. However, you also have to calculate DSO for other companies in the same industry to compare.

  3. berrie says:

    to add on, it is useful to apply ‘common sense’ in assessing a company’s business model and make comparison with similar peer companies. E.g. a company like SMRT receives daily cash collection and prepaid money stored value cards and it does not make sense to have long trade receivables days. For Silverbird, if their trade receivables are perpetually high all the time, it could signal their customers are not good paymasters or their products require a long inventory cycle to generate actual cash to their bank account. These are just for illustrations. I do not follow the topics of these 2 companies. =)

    • Hi berrie,

      DSO analysis usually applies to companies who have customers who pay on credit and does not really apply to cash transaction companies such as public transport, restaurants etc.

      Trade receivables which are high compared to sales (DSO) is a signal of poor credit policies.
      For inventory cycles, you would have to look at another metric Days On Hand (DOH), the longer the Days, the more inventory you are holding which eats up your cash.

  4. Raymond Lim says:

    Hi Calvin,

    Since, you have divested SPH and SMRT, would you consider to divest SingPost too ?

    I have read Investment Moats that SingPost is expanding to logistics and there was change of Management Team, expect that the dividend may be reduced and earning from the core business could be reducing.

    Do foresee or base on your experienced analysis, SingPost could be another SPH where both core earning could be reducing ?

    I have invested in SIA counter however SIA profit has dropped and I have read forum that the SIA serice quality has dropped and there were complaint that the change of the SIA websit is diffcult to use and navigate, and there was comment that the SIA website looks like ‘dog breakfast’. Sigh…. SIA price has dropped alot from 14 zone to 10 zone.

    It is investible in SATS and SIA Engineering counters ?

    Many Thanks here.

    • Hi Raymond,

      That’s a good question. I have considered reducing my stakes in Singpost given the current rally, but not completely divesting Singpost.

      Some of the reasons are Singpost just issued $350 in prepetual securities at a very low rate of 4.25% compared to all other issuers like Noble, Genting etc. I would like to see how Singpost can put that money to good use, they just have to yield returns above 3.5275% (4.25% x (1-17%)) after tax cost of debt to be accretive. With a net cash of over $200mil and minimal capex going forward, Singpost has plenty of firepower for acquisitions.

      Unlike print media revenue which is declining for SPH, mail revenue remains stable for Singpost. Also, Singpost has actively shifted its revenue base to include new businesses such as logistics and retail services.

      My personal opinion is that dividend policy will stay intact due to strong operating cash flows, minimal capex requirements and strong net cash position. Unlike SMRT which has just cut dividends and SPH which has inconsistent dividend track record, Singpost has an untarnished dividend track record.

      SIA is facing a lot of problems as there is a huge shift in market fundamentals. Even businessmen are taking budget airlines, leaving SIA behind. SIA, given the inflexibile and high cost structures is unable to compete and cannot transform to meet the challenges. It is hard to say if the new budget carrier by SIA, Scoot will make any difference. Including the uncertainty in fuel costs, I would stay away from it.

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