First test:
If trade debtors amount in Balance Sheet is bulky, with collection period exceeding three months, drop every analysis. Save your breath for a better company.
It is the same for inventories/ stocks. If stocks amount in Balance Sheet is bulky, with stocks turnover period exceeding three months, drop every analysis. Save your breath for a better company.
Generally, a company with long collections period and inventories turnover is either operationally badly managed or having problem in generating sales. Either way, we should not waste our time and money to invest in such company.
Second test:
First, let’s calculate the net total of Stocks Add Trade Debtors Less Trade Creditors (S+TD-TC). Second, we calculate the movement of S+TD-TC of two Balance Sheets period.
If S+TD-TC movement increases, we have to worry. If S+TD-TC movement decreases, we are relief. If the increase of S+TD-TC is almost the same as Net Profit add Depreciation, we are quite sure that the company has not made a single sen of real profit yet. There is no hard cash from the profit.
However, if the revenue increase proportionately, not less, such increase in S+TD-TC is acceptable. Should S+TD-TC increases for two quarters or more without the proportionate increase in revenue, dump the shares.
This is all about Step 3. A company that does not pass the screening test is either badly managed or manipulating their numbers. We cannot differentiate the two, but either way we should not invest in such company.
Click here for further explanations.
Part 1: Reading financial statements
Part 2: The principle of profit manipulation
Part 3: Detecting profit manipulation - Overview
- Step 1 - Net profit and depreciation
- Step 2 - Net cash or debt movements
- Step 3 - Stocks add trade debtors less trade creditors
- Step 4 - Capital expenditure, goodwill, tax and dividends
- Step 5 - Other debtors and creditors
- Concluding Steps
