Why is it important to look beyond the numbers to avoid loss?

Understanding and interpreting financial statements is very crucial for anyone planning to make an investment decision or forecasting future stock prices. However, making a sound financial and fundamental analysis of a company involves more than just numbers. It is important to look beyond the numbers to avoid loss.

Very often these financial statements do not provide the actual position of a company. There have been a number of instances where the management of a company has inflated the numbers in the financial statements to present a better position to the investors.

The negative impact of financial frauds:

In recent years, there has been an upsurge in the number of financial scams and fraud involving large corporate houses. These financial scams have proven to be a disaster for the long term investors and have created an adverse environment in the stock markets. These scams are not only affecting the investors and stock markets, but also have an adverse impact on all the stakeholder of a company such as the employees, financial lenders, customers etc.

One can witness the negative impact of these financial frauds in the recent case of the infamous Punjab National Bank scam. Once the news of the scam was out, there was a sharp decline in the stock price of the bank. The stock price had plunged to half in a month’s time.

How to safeguard your money?

In order to safeguard the money invested in stock markets, an investment decision should only be made after making a sound qualitative analysis of the company to look for the warning signs which might jeopardize the investments in the future. Example of a few warning signs have been illustrated below for a better understanding:

A company routinely has high revenues/ profits but low cash inflows. Sales can be easily manipulated by the management, however, cash flows cannot be manipulated by the management. Growth in the revenue of a company without a corresponding growth in the cash flows is a warning sign

A company has overvalued its assets/ undervalued its liabilities. Very often, the management tends to inflate the value of its assets to present a better picture of its financial position

An increase in the growth rate of the revenue even when the overall market performance is low is another indication of a potential financial fraud.

Red flags to look for exiting an investment:

In order to avoid negative returns on your investments, it is advisable to not invest/ exit the investment immediately if you come across any of the red flags given below:

  • You don’t really understand the company’s financial statements. You should never invest without having an understanding of a company’s current financial position
  • Accounts receivable and the stock inventory is increasing faster than gross sales revenues of the company. This might indicate poor management decisions
  • The company is making aggressive acquisitions of smaller companies, especially in unrelated fields
  • The company’s majority of the revenues are coming from one key customer. The company’s performance might decline drastically if the company loses that customer.
  • The company’s majority of the revenues is tied to one key product. Firms that focus on a single product are often efficient, but a lack of diversification also increases risk because having revenues from several products stabilizes profits and cash flows in a volatile world
  • The company’s majority of the purchases is from a single supplier. Depending upon a single supplier increases the risk of an unanticipated shortage of inventory and may affect the sales/ profitability of the company
  • The company is facing a lot of competition in the market. Increasing competition tend to lower the prices of the products/ services and further leads to a reduction in the profit margins; so when forecasting future performance, it is important to assess the likely actions of current competitors and the entry of new ones.
  • The company is not investing continually in research and development of new products/ services or to improve existing products/ service. It is crucial for a company to have a strong research and development base since all the future prospects of the company will depend critically on the success of new products/ services in the pipeline.
  • Are changes in laws and regulations likely to have on the business of the company? For example, when the future of electric utilities is forecasted, it is crucial to factor in the effects of proposed regulations affecting the use of coal, nuclear, and gas-fired plants.

However, please note that none of the items mentioned above automatically means there is something wrong with the company—instead, the items should be viewed as warning signs that cause you to take a closer look at the company’s financial positions and performance before making an investment decision.