(not an expert)

Given fraud/profit warning is as prevalent in the stock market (Carillion, WorldCom, Enron, Olympus etc), just thought this might be helpful when people do their DD. Simple and objective check list. I plan to build a spreadsheet that tracks this for any companies (requires manual input tho), let me know if there are interest.

Interesting write up on how to identify red flags and avoid bad investments (with evidence!). Basically, the article analysed past accounting scandals, big and small companies, and compile the stats that has the highest positive correlation to fraud.

I've also verified this list from wikipedia

https://en.wikipedia.org/wiki/Accounting_scandals

By triangulating, these three simple ratios and their subsequent demise. The conclusion is that >75% companies on the list of who exhibits unfavorable financial ratio (discussed below) over an average 7 years, subsequently got involved in either massive profit warning, accounting fraud, filing Chap 11 or massive restatements in their financials.

I'm gonna summarize it as I understand it, so please correct me if I'm wrong. Source.

Financial ratios

a) Debtor/Sales (Accounts Receivables/Sales) ratio

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. Rule of thumb is that red flag would be raised if it consistently breached 25%. Chart here.

Conclusion: The higher it is, the more negative to the company

b) Creditor/Cost of Sales (Accounts Payable/Cost of Sales) ratio

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.

Conclusion: The higher it is, the more negative to the company

c) 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.

Example: Folli Follie's fraud, see chart here.

Conclusion: The higher it is, the more negative to the company

Hope it helps and let's make some money this week!

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