Red Flags for a Financial Analyst

As I study for my Level I CFA Exam, I'm reading Financial Statement Analysis by Fridson and Alvarez. Everything I've written below is learned from them, but in my own words...this helps me to understand the information better. Thanks for your patience!


If you're a financial analyst, ploughing through voluminous balance sheets, income & cashflow statements, then you're likely looking for a few handholds. You need to know the key signs of what will be either a positive or oftentimes (in this market) negative analysis report.

One of the red flags that oftentimes preceeds failure to meet future earnings are unrealistic sales increases in the current and/or prior quarters. Oftentimes, managers will incent higher-then-expected sales increases in order to meet a bonus (especially if the bonus is based off Earnings-per-Share rather than shareholder equity). Look for these at the end of the quarterly reporting period. This practice, however, must be 'paid for' in the future, which will likely depress sales, thus further depressing earnings.


Another telltale sign of a company that is on a downward slippery slope is a senior executive resigning. Consider Wachovia Bank's removal of CEO Thompson back in June. This was after several writedowns, due to their deteriorating Option-Arm portfolio (which continues to erode shareholder equity). Additionally, senior execs may resign due to the pressure from the Board to meet quarterly numbers...they may know that this "GAAP-allowable" bending of the numbers may be the straw that breaks the camel's back...so they resign.

Further, and a bit more obvious, is an earnings restatement. Companies oftentimes, as a result of an audit, investigation by the SEC, or new accounting rules will restate their previous earnings even though they deemed those earnings allowable under GAAP standards. What starts to be one inquisitive question by a financial analyst may end up in an entire slew of earnings restatements, thus further eroding shareholder equity.

This one should be obvious, but oftentimes, to investors, it is the reverse. Managers of companies that have been pinpointed by analysts as reporting erroneous figures will often lash back vehemently with a defensive, almost formulaic, statement. They will say their accounting conforms to GAAP, they are meeting their goals, and other various and sundry chants. Consider Freddie Mac's recent statement that they are "well capitalised" even while Treasury Secretary Hank Paulson was working to get Congressional approval to use taxpayers funds to keep Freddie's stock price up by buying as much stock as necessary...and 'unlimited' use of funds! But, some people really are that gullible! Maybe it comes from our motivational speaker culture, us looking in the mirror and telling ourselves we really are that good...

Additionally, when a company delays their earnings reports, that would probably be a good time to short them. Or, at least buy a put or two.

Also, management can play the red herring logical fallacy. They can point to an independent auditor's stamp of approval on their earnings reports. While that can be a check and balance, a savvy investor should not let that satiate them entirely.

Lastly, an increase in working capital can be a bane to a company, but not recognized as such by investors. For instance, if I'm a clothing manufacturer, and I produce a new line of clothing that simply falls flat on its face, chances are that I don't want to write if off and incur a huge loss that quarter, highly increasing the chance I'll miss my quarterly numbers. So, I keep it in inventory, thus delaying the final writeoff...which has to come sooner or later. It costs to keep the product in inventory, this cost is part of my working capital. Alternatively, I could extend credit to non-creditworthy borrowers and delay the amount of time required to collect, extend their payment periods, thus delaying eventual collection. (Freddie Mac just extended their foreclosure procedure from 4 months to 10 months...) As a result, I'm carrying these costs longer, which drains shareholder equity because of the increased working capital.

Those are just a few red flags that should be detected by a knowledge-hungry analyst...not just one who likes to plug in numbers, but one who likes to ask "WHY?".