Five red flags in financial statements

The problem with looking for one big clue

Most people read financial statements hoping to spot one shocking number. A loss that came out of nowhere. A debt figure that looks too large. That instinct is understandable, and it rarely works.

Problems in accounts almost never sit in one line. They show up as a mismatch. Profit says one thing, cash says another. Sales grow at one speed, receivables at another. The company holds a lot of cash and still borrows heavily.

So the useful question is not "is this number bad?" It is "do these numbers agree with each other?" The five checks below are all versions of that question.

One more point before we start. A red flag is not proof of fraud. Many red flags have honest explanations. Your job as an analyst is to find the explanation, and to notice when the company does not offer one.

Red flag 1: profit that never turns into cash

Net profit is calculated using accrual accounting. A sale counts as revenue when it is made, even if the customer has not paid yet. That makes profit a useful measure, but also an easy one to stretch.

Cash flow from operations (CFO) is harder to fake. Money either came into the bank or it did not.

In a single year, CFO and net profit can differ for good reasons. Over five years, they should broadly track each other for a stable, healthy business. When they do not, ask why.

Illustrative example. A company reports net profit of ₹100 crore every year for three years. Its CFO over the same years is ₹30 crore, ₹20 crore and ₹10 crore. Cumulative profit is ₹300 crore. Cumulative operating cash is ₹60 crore. Only one rupee in five of reported profit has shown up as cash.

A simple habit: add up five years of CFO and divide it by five years of net profit. A ratio well below 1, with no clear reason such as fast growth, deserves a closer look.

Red flag 2: receivables growing faster than sales

When customers are slow to pay, the money owed to the company (trade receivables) piles up. A little of that is normal. A lot of it, growing faster than sales, can mean revenue is being booked too early, or booked for sales that will never be paid.

The cleanest way to track this is receivable days, also called days sales outstanding (DSO):

Receivable days = Trade receivables ÷ Revenue × 365

Illustrative example. Revenue rises from ₹1,000 crore to ₹1,150 crore, a 15% increase. Receivables rise from ₹164 crore to ₹238 crore, a 45% increase. Receivable days move from about 60 to about 76. On average, customers are now taking more than two weeks longer to pay.

Look for the same pattern in inventory days. Stock that keeps building faster than sales can mean products are not selling, or that inventory values are overstated.

Red flag 3: cash on paper that does not earn

A large cash balance usually looks reassuring. Be careful when a company reports big cash holdings and also carries large borrowings at high interest. A well-run company would normally use spare cash to repay expensive debt.

There is a quick test. Divide the interest income in the profit and loss statement by the average cash and bank balance. If the cash is truly sitting in bank deposits, the implied yield should be close to deposit rates. If a company reports ₹2,000 crore of cash but earns only ₹20 crore of interest on it, that is a 1% return. Either the cash is restricted, pledged or held somewhere unusual, or the balance itself needs questioning.

This is not a theoretical worry. In January 2009, the founder of Satyam Computer Services admitted that over ₹5,000 crore of its reported cash and bank balances did not exist. So read the note on cash and bank balances. Check how much is in fixed deposits, how much is restricted or under lien, and where it is held.

Red flag 4: money moving to related parties

Related parties are entities connected to the company, its promoters or its key managers. Transactions with them are legal and common in India, where business groups often have many linked companies. The risk is that value leaks out of the listed company to entities the promoter controls more directly.

Two places to read:

• The related party note in the financial statements, prepared under Ind AS 24.
• Form AOC-2 in the board's report, which lists material contracts with related parties.

Watch for loans and advances to group companies that keep growing, large purchases from or sales to a related entity, guarantees given for group borrowing, and investments in unlisted group firms that are later written off. A useful check is to track related party transactions as a share of revenue or net worth over several years. A rising share is the warning, not the existence of such transactions.

Red flag 5: shifts in the auditor and the accounting policies

Some of the most useful signals are not numbers at all.

• Auditor changes. An auditor resigning in the middle of its term is a serious event. Listed companies must disclose the resignation along with the reasons the auditor gave. Read them.
• Modified opinions. A qualified opinion, or an "emphasis of matter" paragraph, tells you the auditor wanted to draw attention to something. Read the paragraph, not just the conclusion.
• Policy changes. A switch in depreciation method, revenue recognition timing or capitalisation rules can lift profit with no change in the business. The effect is usually disclosed in the notes.
• Profit that leans on other income. If a growing share of profit comes from other income or one-off gains, the core business may be weaker than the headline suggests.

Limits of these checks

Each flag can fire for honest reasons.

A fast-growing company naturally ties up cash in receivables and inventory, so its CFO lags profit. Infrastructure, EPC and government contractors often have long receivable cycles as a normal feature of the industry. Seasonal businesses can show odd year-end numbers. And for banks and NBFCs, the cash flow statement tells a very different story, so these checks do not transfer.

That is why two habits matter more than any single ratio. First, look at three to five years, not one. Second, compare with two or three close peers. A receivable cycle of 120 days is alarming for a consumer goods company and ordinary for a defence supplier.

A ten-minute screening routine

1. Add up five years of CFO and net profit. Compare the two totals.
2. Calculate receivable days and inventory days for each year. Look for a steady rise.
3. Divide interest income by average cash. Compare the result with deposit rates.
4. Open the related party note. Track loans, advances and guarantees to group firms.
5. Read the auditor's report in full, including any emphasis of matter.
6. Scan the accounting policy note for changes from the previous year.
7. Check each finding against two peers before concluding anything.

The reframe

A red flag is not a verdict. It is a spot where the numbers stopped agreeing with each other. Sometimes the explanation is ordinary. Sometimes the company never gives one. Learning to tell the difference is most of the work.