In general poor quality earnings, typified by
- Increasing earnings
- But no increase or even decrease in cash (in China this might be manipulated)
- Rise in Inventory (inventory might be worth less than valued)
- Rise in Receivables (might include fake receivables or difficult to collect)
- Rise in Debt (often short term)
There are other things to look for, for instance:
- Rights Issues that make no sense: companies that claim to be highly profitable, but need lots of cash in the form of Rights Issues
- No dividends or very low dividends
- High Margins: normally that is what we want as investors, but in competitive industries margins that are much higher than competitors are a potential red flag
- High Sales compared to low Property, Plant & Equipment, if the last one is too low, than the Sales are possibly bogus
- Interest Received versus Interest Expenses, if the company claims to have a lot of cash versus debt, but the Interest paid is much higher than Interest received, than something is likely wrong
- Basic Numbers checking: for instance Bernie Madoff claimed to turnover a larger amount of options than the total amount that was traded.
- Related Party Transactions: always a source of potential problems
- Dubious brokers and accountants (note that Top Tier accountant companies have been involved with huge frauds, they are not a guarantee that all is well)
A selection of interesting articles from Bronte Capital, all China related, how to "kick the tires" of a Balance Sheet and Profit & Loss statement:
And the danger of short selling:
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