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