If the entire profit is almost equal to the net movement of S+TD-TC, the answer is NO. In such a case, the company is either
a. Operationally badly managed
b. Manipulating profit numbers, or
c. In the phase of growth
We cannot differentiate a. and b., but it doesn't matter. Both reasons are good enough for us to avoid investing in such company. Other steps provide us information how the company uses its profit.
The checking begins with Step 2 - movement of cash and bank balances. What if the Cash and Bank Balance is faked?
Faking profit through cash and bank balance is the last thing that accountant or management wants to do. It leaves trail in bank reconciliation or cheques books. In corporate world, the best lie is the lie that can be justified professionally due to subjectivity. For instance, there are various methods for stock valuation that lead to different numbers; performing and non-performing loans can be subjective; timing of billing can be arguable, particularly for construction and IT companies; vendors can be blamed for late billings and that accrual was not done due to staff omissions. These are the grey (and safe) areas that accountant and management want to exploit.
Only in a desperate situation, where all means of profit manipulation were exploited, the management will take the risk of creating fake cash for profit. In such a case, Step 3 would have revealed such badly managed company. We would have avoided investing in it right at the beginning.
Nobody wants their company to be badly managed, including those who manage it. It depends on the management integrity in reporting the truth. However, if the management chooses the evil path of deceiving, the first step of evil path (or selling soul) is always the easiest (or the seemingly harmless) step, i.e. S+TD-TC. (Step 3)
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
