As earnings season for the 1st quarter approaches, I thought I’d pass on this BusinessWeek article that is almost like a handicappers’ guide to spotting earnings red flags and number massaging. If you are daytrading, earnings season can be a veritable Candyland, with sharp swings and volatility at every turn. For those of us who are are in the unenviable position of having to hold stocks for more than a day or so, earnings quality is a real issue and something that we can be vigilant about in defense of our portfolios.
One way to gauge the relative safety of stocks is to distinguish companies whose earnings are more likely to be sustainable over time from those whose profits may prove short-lived…of the three statements that make up a quarterly financial report, by far the least susceptible to accounting manipulation is the cash-flow statement.
In the article, the writer lists the major areas on these statements where there is enough “cloud cover” to finagle the ingredients that make up a company’s earnings report. These include:
Write-Offs Against Goodwill – Especially crucial for acquisitive companies and how they determine book value.
Credit Quality – Is the company extending too much credit to its customers just to close sales?
Inventory Issues – Will inventory written down today make results look better in the future when said “worthless” inventory actually gets sold?
Accounts Receivable – cutting this number can make cash flow look much better…temporarily.
Deferred Tax Assets – When does the net operating loss carry-forward expire?
Incongruities – Are asset levels and depreciation in step with each other?
For many Wall Street participants, some of these terms and concepts may be like a foreign language. This is a great chance to have them broken down and explained using examples of companies you’ve probably heard of and can relate to.
Good luck this earnings season and keep your eye out for the Games People Play.
Full Story: Earnings Red Flags (BW)