Wednesday, November 16, 2005

Limitation and exception

This method of detecting profit manipulation is particularly effective for manufacturing and trading companies. It is also useful for the industries like service, infrastructure, construction, property development, information technology, mining, etc. Understanding of the principles behind the practice is useful in applying the method.

However, it may rule out most construction or property development companies as badly managed due to the industries' huge stock piles and uncollectible debts. (It is also a good reason for us not to invest in the companies of such industries.) For infrastructure companies, we have to accept its high gearing ratio as reasonable since the income is contractual.

It is not applicable for financial services companies like banks, stockbroking, insurance, etc. While the principles of managing company are the same, they are reflected differently in the Balance Sheet. There are more rooms for such companies to manipulate their profit without reflecting such manipulation in the Balance Sheet. For instance, how do you know their marketable securities are valued correctly (market price for illiquid stock are not indicative as real disposable value), how can we be sure that they have declared or provided for non-performing loans, how can we be sure within the reporting period they wasn'’t any off balance sheet items took place, how much is the company's foreign exchange risks, etc). The transactions in financial services companies are much more complicated than the companies in other industries.

Historical performance is the key to understand their real performance other than merely checking their Balance Sheet'’s movements. For instance, growth story behind a dismal historical performance is unreliable.

Enron is an odd case. It will escape our attempt to detect profit manipulation, simply because it didn'’t consolidate the results of all the companies within the Group. Enron created certain corporate structure that, under U.S. accounting standards, allowed it not to consolidate these loss making companies into the Group accounts. Luckily such loop hole is only available in United States. Malaysia adopts International Accounting Standards, a principle-based Standards just like U.K., Singapore, Hong Kong, etc.

Enron used off balance items in constructing their profitability. To overcome such deception, we must look at the Notes to the Accounts for such off balance sheet items like corporate guarantees, capital commitments, contracts, options written, etc.

Part 1: Reading financial statements
Part 2: The principle of profit manipulation
Part 3: Detecting profit manipulation - Overview
Part 4: Exceptions and limitations

Detecting profit manipulation - Concluding Steps

The question to be answered for the entire 5-step-exercise is that "Does the profit generate real cash?"
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
Part 4: Exceptions and limitations

Monday, November 14, 2005

Detecting profit manipulation – Step 5

Step 5 - Other creditors and debtors

If ultimately the movements in Balance Sheet that match the funds from profit are the movements in other creditors and other debtors, we must know the reasons of such movements. Such information is usually not available in quarterly report and sometimes not even available in annual report.

The way to deal with such movements is to wait for next quarter’s Balance Sheet. Such increase in other debtors or other creditors should be of temporary. It should be alarming if the amount keep increasing in Balance Sheet for two quarters.

It can be due to something as simple as payment or repayment of rental deposits, down payments of agreement, etc. Therefore it should be either of something one off or short term.

Part 1: Reading financial statements
Part 2: The principle of profit manipulation
Part 3: Detecting profit manipulation - Overview
Part 4: Exceptions and limitations

Friday, November 11, 2005

Detecting profit manipulation - Step 4

Step 4 Capital expenditure, goodwill, tax payment and dividend

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 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
Part 4: Exceptions and limitations

Friday, November 04, 2005

Basic understanding of inventories, trade debtors and trade creditors

When the profit is not reflected as positive net cash or net debt movement, the natural places to look for the profit are trade debtors and inventories/stocks.

Stocks, trade debtors and trade creditors are the natural path of business process.

When vendors deliver stocks or raw material, trade creditors and stocks increase. When a sales is made, stock reduce, trade debtors increase. When the company pays its vendors, trade creditors reduce. When the clients pay, trade debtors reduce.

When stock is obsolete, stock amount in Balance Sheet will increase. When clients refuse to pay, trade debtors increase. While the company still need to pay its trade creditors.

Essentially, trade debtors, stocks and trade creditors reflect business process in financial terms.

So it is BAD SIGN when stock and trade debtors increase. There is only ONE exception that should be tolerated by investors, with very strict conditions. We will deal with it later.
There are three reasons why S+TD-TC increase,
  • Bad operation, i.e. bad collection period, bad stock management, bad purchasing process, etc.
  • Profit manipulation, i.e. reversing previously provided provision for obsolete stocks or bad and doubtful debts, not making provision for uncollectible debts, not making provision for
  • Revenue growth

First and second items are bad. Third item MAY BE good, if the revenue growth exceeds the S+TD-TC's growth, proportionately. We, thus, need to do further calculation.

Calculate Net S+TD-TC turnover days:
S+TD-TC / Revenue (Turnover) per annum x 365, OR
S+TD-TC / Revenue (Turnover) per quarter x 92

Compare the number of current period with preceding period and previous year corresponding period. If current period’s S+TD-TC turnover increase (deteriorate/ slower/ lower) it reflects deterioration of operation efficiency or profit manipulation.

We can then further analyze the turnover days of each item, i.e. inventories/ stocks, trade debtors & trade creditors, separately.

Back to Step 3: inventories/stocks, trade debtors and trade creditors.

Detecting profit manipulation - Step 3

Step 3: Inventories, trade debtors and trade creditors movements

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
Part 4: Exceptions and limitations

Understanding trade debtors and stocks

The net amount of "Stocks Add Trade Debtors Less Trade Creditors" (S+TD-TC) reflects business operational efficiency. A well managed company ALWAYS has slim "S+TD-TC"”, which is the reflection of an efficient business operation.

Trade debtors amount, in the Balance Sheet, is SLIM if the collection period is less than two months. Three months period is considered bulky and barely acceptable. For a collection period more than three months, the management is having problem in collecting debts. Investors, run!

Collection period formula:
Trade debtors / Sales (Turnover) per annum x 365, OR
Trade debtors / Sales (Turnover) per quarter x 92

This is the same for stocks. Stocks amount is SLIM if the stock turnover period is within two months. Three months period is considered bulky, low, slow and barely acceptable. For a stock turnover period more than three months, the company is having obsolete stocks that nobody wants, having a big problem in production flow and/or having a bad purchasing process.

Stock turnover period formula:
Stocks / Cost of sales per annum x 365, OR
Stocks / Cost of sales per quarter x 92
* Sometimes there is no data on cost of sales. The alternative is estimated cost of sales = Sales (turnover) x (100% - profit margin%)
The longer the period, the slower or lower the stock turnover and the higher chances of obsolete stocks, bad stock management or bad production flow.

Accounting text books make no effort in differentiating stocks and trade debtors from cash in measuring liquidity. Therefore, when we were students we couldn't figure out whether bulky current assets is good or bad. Now the answer is clear: Bulky Stocks and Trade Debtors are BAD for business. Bulky cash has no harm.

Illustration 1

Consider this fact:
1. Debtors collection period = 3 months
2. Stocks turnover period = 3 months
3. Creditors payment period = 3 months

This company managed to get their creditors to finance their stocks. However, the company still needs to finance its trade debtors equivalent to 3 months of sales.

Illustration 2
Consider this fact:
1. Debtors collection period = 0.5 month
2. Stocks turnover period = 1 month
3. Creditors payment period = 3 months

This company managed to get their creditors to finance their stocks and debtors. It is reflected in their Balance Sheet that the company doesn't have to spend a single penny in operation. Good business.

AEON Co. (M) Bhd (Jaya Jusco) is the perfect example of Illustration 2. On their supermarket retail business, AEON has no debtors (cash business), high stock turnover (less than one month) and get their suppliers (Creditors/ Payables in Balance Sheet) to give 3 months payments period. The suppliers is financing AEON's stocks, debtors, cash and part of their capital expenditure. Check out their balance sheet here, AEON has negative S+TD-TC. This kind of business, that let the creditors to fund its operation, is the extreme of the above example. But the idea should be illustrated well.

By refusing to provide and charge out obsolete stocks and/or bad and doubtful debts to income statements as expenses, the management is manipulating profit. Naturally the Balance Sheet looks bulky.

The worst case scenario is that the management decides to reverse previously provided provisions, therefore increase the stocks and/or debtors amount in the Balance Sheet and create fake profit. This shall reflect as a big positive movement in S+TD-TC.

In a nutshell, bulky S+TD-TC is BAD and slim S+TD-TC is GOOD. Positive movement (increase) in S+TD-TC is BAD. Negative movement (decrease) in S+TD-TC is GOOD.

The exception is revenue growth. Even in such a case, debt collection period and stock turnover period should not deteriorate.

Back to Step 3: inventories/stocks, trade debtors and trade creditors.

Tuesday, November 01, 2005

Detecting profit manipulation - Step 2

Step 2: Net cash/ debts movement

The first question to answer is, “Does the profit bring in real cash?”

In order to know whether there is improvement in a company’s financial position, it is useless to look at cash and bank balances only. We must see the NET of Cash, Bank Balances and TOTAL Borrowings, in order to know whether the profits bring in real cash.

Calculate the change of net cash/(debts) between two Balance Sheet dates. We need to know the movement of net cash/(debts).

Net Cash/(Debts) = Total Cash & Bank Balances – Short Term Borrowings – Long Term Borrowings. The company is EITHER in a net cash position OR net debt position. We calculate the movement of net cash OR net debt.

Get the movement amount out and compare it with Step 1’s Net Profit Add Depreciation. We also need to find out more of other movements in Balance Sheet to know the whole picture.

This is all for Step 2.

Positive movement, i.e. increase of net cash or reduction of net debt, that match Net Profit Add Depreciation indicates possibility of true profit, though we cannot conclude it before looking at other movements in the Balance Sheet.

We have to worry about negative movement. What makes a profitable company to have deteriorating cash or financing position? It can be due to capital expenditure, it can be due to dividend and/or tax payments. It can be due to deterioration of operating efficiency or profit manipulation that cook up the stock and debtors level. We will need to find out.

Cash flow statement is not very helpful in detecting accounting manipulation because it split out the changes in cash and bank balances from the changes in borrowings.

Part 1: Reading financial statements
Part 2: The principle of profit manipulation
Part 3: Detecting profit manipulation - Overview
Part 4: Exceptions and limitations