Sometimes, despite showing net profit, there is no significant change in net cash/debts and/or S+TD-TC. We must then look elsewhere to find out where were the funds gone (for real profit) or where were the profits juggled from (for fake profit).
The items listed below are usually NOT “alarming” items in detection of profit manipulation. There are more of “assuring” items on providing us a full understanding of where had the money gone. The judgments on “whether those are good management decisions” are business calls.
Capital expenditure
Movement of fixed assets shows capital expenditure.
Fixed assets as at current period end = Fixed assets as at preceding period end + capital expenditure - depreciation
Company may acquire fixed assets like plants and machineries, vehicles, lands, office equipments, computers, etc. Accountants may hide losses by charging repair and maintenance expenses to fixed assets as capital expenditure. However, as fixed assets are important items for taxation, they are subjected to careful scrutiny by auditors and tax agents. Accountants will usually avoid using fixed assets as a way to manipulate profit.
For the purpose of detecting profit manipulation, there is nothing alarming should the funds from profit were used for capital expenditure. Whether such capital expenditure is good or acceptable to the investors is the matter of business judgment.
Goodwill
Goodwill increases when the company acquires subsidiaries with a price more than the subsidiaries’ book value.
Tax payment
The increase of tax recoverable or reduction in tax provision in Balance Sheet is, sometimes, due to cash payment to IRD. However, we should double check income statement’s taxation row (below profit before tax, above profit after tax).
Sometimes the accountant may decide to reverse tax provided which would jacked up profit after tax. Do a quick check by dividing tax over profit before tax. A range between 20% and 35% is acceptable depending on industry.
Dividend payment
Dividend payment would reduce net cash or increase net debt.
Retained profit as at current period end = Retained profit as at preceding period end + profit – net dividend
At this point, most likely you have got a rough picture on whether the profit generates cash or on how the company utilized its profit.
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
