Read the small print: Earnings season tips for spotting red flags on financial statements

As the third-quarter earnings season ramps up, markets are paying close attention to corporate financial statements. Meeting or beating expectations can have a critical impact on a company’s stock and, in many cases, management bonuses.
Companies that trade on large stock exchanges such as the Toronto Stock Exchange are compelled to follow accounting rules laid out in the generally accepted accounting principles (GAAP) to allow apples-to-apples comparisons, but there are still ways to make bad news look like good news.
“GAAP is as good as it gets,” says Zachary Curry, portfolio manager at Toronto-based Greenrock Capital Partners Inc. But he adds that corporations can easily skirt the rules to make their quarterly financial statements look better to unsuspecting investors and their advisors.
As an example, he says red flags can sometimes appear as adjustments in the footnotes.
“The regulators have made it so that if there are adjustments, they have to be described and footnoted. It’s in the notes, but they’re are often in smaller print,” he says.
Mr. Curry adds that footnoted adjustments could reveal hidden signs that a company is struggling.
“If you have one, it’s okay, maybe, but if you start to get adjustments all the way up in the earnings statement, that’s a sign you should be digging a lot deeper,” he says.
Adjustments that raise red flags for Mr. Curry include changes to net income, earnings before interest, taxes, depreciation and amortization, and gross profit margins.
“You have to go through and look at what those adjustments are,” he says.
However, he adds that not all adjustments are bad news. They can be quite common depending on the nature of the business.
“If there’s one adjustment, and it’s consistent and it has always been that way for five years, you build a bit of a comfort level with it and the market doesn’t seem to mind,” he says.
In other cases, he says adjustments could be a one-time event and it’s important for advisors and money managers to understand the business and its management.
“There are also some advisors who are investors in a company [and] would know the management team and listen to the conference calls,” he says.
The motives behind financial statement manipulation are often aimed at giving the company’s stock a short-term boost by persuading investors it’s undervalued.
While quarterly earnings reports are meant to focus on a company’s operations, Liz Miller, founder and president of Summit, N.J.-based Summit Place Financial Advisors, LLC, says in many cases the company’s share price is the elephant in the room.
“I believe management never looked so great as when a stock is doing well and never looked so poor as when a stock is not doing well,” she says.
Investors rely on certain universal valuation metrics such as the price-to-earnings ratio to show the relationship between the price of a stock and the company’s latest earnings. Management can tweak those metrics in their favour by casting earnings in the best light, but Ms. Miller says past earnings could mask problems with earnings in future quarters.
“Trailing earnings are yesterday’s news,” she says. “To our mind, valuation is Part 2. Part 1 of fundamental analysis is the company itself, including less measurable things, such as strategy and organization.”
This quarter, Ms. Miller is focusing on how companies are coping with the shift from a high-inflation economy – specifically those that boosted sales volumes by pricing their products low.
“In an inflationary environment, it was important to see that companies could maintain revenue growth by pushing pricing through. When inflation is coming down, you want to make sure companies have unit growth coming through,” she says.
She points to the technology sector as an example of how companies, such as Apple Inc., could boost revenue growth by cutting prices.
“Tech has always been a unit story because it’s an industry in which pricing, by definition, is always coming down. Even though we’ve been in an inflationary environment, you didn’t see a lot of price increases across that sector, but we saw the secular change in demand for a lot of units,” she says.
Another telltale sign she looks for in a lower-inflation environment is inventory levels.
“We want to see trends of inventories being maintained but not building up too much. That’s always an early signal that perhaps demand is slowing,” she says.
“We’ve seen some companies for which inventories have started to build, and that’s a yellow flag.”
Ryan Modesto, chief executive officer of i2i Capital Management in Toronto, sees red flags when statements show earnings or income growing at a faster pace than revenue.
“You can get companies that are cutting back on costs more aggressively than they should, or they’re buying back shares just to get the earnings number higher to draw attention away from a lagging revenue growth number,” he says.
“It’s one of those trends that can’t go on forever,” Mr. Modesto says. “Just be aware of companies that are going out of their way to do one-time cost savings to get their bottom line higher because they can’t always control the top line.”
He also looks for red flags under receivables (amounts owed to a business) to find out if they’re growing at a faster pace than sales.
“It could mean the sales are becoming lower quality. It could mean the company is having trouble collecting from their customers or maybe the companies are overselling into some of their customer channels,” he says.
One potential warning sign he says you can’t find in the financial statement is management’s ability to meet or beat the guidance they provide to analysts consistently.
“If you have a company that continually misses revenue and earnings expectations every quarter, that can be a red flag because it can mean something isn’t working in the business as they expect, or the management team doesn’t have a great handle on the business,” he says.