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