‘RED FLAGS’ – What To Look Out For In Company Corporate Filings by Analyst Doug Rogers

Editors Note: 

Before we bring you the first part of the free, three-part series by Doug Rogers on Corporate Filings, Stockupticks has come across a company that we’re considering for a full profile that might be of interest to some of you early birds. Clean air requirements have turned the auto emissions business into an enormous market and Environmental Solutions Worldwide, Inc. (OTCBB: ESWW) is a research and development company that develops, manufactures, and markets environmental technologies and products. The Company's products include catalytic converters and spark plug injector technology, both of which result in lower emissions, and ESWW has done extensive research and development in cleaning up diesel fuel emissions. ESWW has several products that are currently making their way through the industry supply chain so keep watching Stockupticks for a more in-depth report!

As part of our ongoing efforts to keep our readers on top of the ever-changing investment business, Stockupticks is once again excited to being you financial insight from analyst Doug Rogers of ManageSource Research. Doug has previously written exclusive articles for our readers on the composition and operation of NASDAQ and on the typical small-cap company and its place in the market. 

Today, he covers a crucial topic for investors by providing insight into public company corporate filings. What they are, how investors can identify trouble spots on a corporate balance sheet and how to interpret content that can often be confusing or contradictory. In light of the recent controversy surrounding reporting methods and the very complicated use of language that came under congressional scrutiny in the Enron/Arthur Anderson hearings, this review by Doug couldn’t have come at a better time. 

Please read on, we think you’ll be enlightened and refreshed to learn there is a way to decipher the ‘numbers-talk’ and ‘jargon’ often used by accountants and financial officers in corporate filings. 

Clients and investors alike are constantly asking us what to look for in a company’s financial results and corporate filings.  In the broad wake of the Enron debacle, and now with similar allegations in the Telecom industry, I thought I would take some time to identify what we look for in a company’s financial statements and what questions we consider when analyzing a company’s data.  This, however, is only the beginning of the research analyst’s job. 

Once we have a firm grasp of the current and historic financial condition of the company, it becomes our job to develop, with a fair degree of accuracy, what the future potential revenue and costs of a given company may be over the next three to five years. We then consider their position in their particular market space and produce price targets and recommendations based on our findings.  In this article, the first in a series of three, I’d like to provide the reader with some practical means of identifying some potential shortcomings in a company’s corporate filings with the hope that you may be able to avoid purchasing shares in companies like Enron in the first place!

The Balance Sheet.  The snapshot of a company’s financial condition!  There’s a wealth of information contained here that may not be completely obvious to the casual observer.  I’m primarily looking for assets, liquidity, short and long term debt and how the company derives the components of each.  If anything seems out of the ordinary, it probably is.  The balance sheet also sets the tone for me with respect to how closely I scrutinize the Statement of Operations and the Statement of Cash flows.  If there are items that concern me on the balance sheet, or items that clearly indicate a desire to “massage” the results, then it’s usually a pretty safe bet that I’ll find the same kind of issues in the other statements, as well.

The first, and most obvious, items that I scan for are extraordinary items.  I categorize these as abnormally large items (financially speaking), non-standard items and incomplete items.  For example, it has become very common in recent years to assign exceptionally high values on Intellectual Property, “good will” and other intangible assets as a means of “boosting” the assets contained on the balance sheet.  Frankly, these are, in most cases, baseless values and have been derived to compensate for deficiencies found elsewhere. 

The “management’s discussion” on financial results will provide some visibility into the accounting for these items; so don’t dismiss an extraordinary item until reviewing management’s comments.  In most cases, however, a company might list $ 50 million in intellectual property rights for software that they purchased, for example.  Investors should scrutinize these items for validity.  Generally, the fair market value for such an item is a mere fraction of what is indicated on the balance sheet.  But it enables the company to balance out significant liabilities and improve liquidity and shareholder’s equity results.  Basically, limited assets combined with substantial liabilities, demonstrates a highly leveraged situation where the company has had to borrow significantly to fund operations, but probably won’t have the assets to service their debt.  Extraordinary items are relatively obvious red flags, but there are other issues to watch out for on a balance sheet.

Analysts utilize “current” and “quick” liquidity ratios as a means of comparing a company’s short-term assets and liabilities.  These numbers demonstrate a company’s ability to meet its current obligations and provide capital for operational expansion.  The current ratio is merely current assets divided by current liabilities, while the quick ratio removes any inventory from current assets.  The rule of thumb results for these are 1.0 and 2.0 respectively.  In other words, a current ratio below 1.0 is considered to be illiquid and conversely, a current ration above 1.0, liquid.  If there are any non-standard or extraordinary items, I’ll usually run the calculations with and without these items to see the overall effect on the ratio results. 

The liabilities section gives me insight into how significantly the company is leveraged with debt and the means by which they’ve financed their operations to date.  I look for credit lines, notes and other such debt instruments.  Debts owed to institutions normally have stricter service requirements while notes to individuals are quite often converted to equity or refinanced by some other means. 

Debt and liquidity are critical to a company’s ability to effectively maintain operations and increase shareholder value from period to period.  I look closely at the items listed as both short- and long-term liabilities.  Debt will drain corporate cash and stifle earnings growth.  Every company has a certain amount of debt, of course, but the question that needs to be answered is whether a company’s debt burden outstrips corporate profits.  Short-term items (12 months or less) are the most critical because they require immediate servicing and have the greatest potential for default by the company.  I’m looking for a reasonable amount of debt in both short and long terms that demonstrates management’s ability to utilize debt when necessary, but not as an operational lifeline. 

Shareholder equity is, simply, the difference between the company’s total assets and total liabilities.  It represents the amount of excess equity available to shareholders.  It can be both positive and negative, but negative shareholder equity indicates an overly leveraged company.  Thus, I want to ensure that the company is moving towards positive equity and not increasing the negative value that could indicate operational costs that far exceed revenue potential, thus necessitating further leveraging to support operations. 

The last item that I would like to point out is paid-in-capital, or the capital infused through equity sales.  Unfortunately, this is very subjective to the type of company you’re analyzing, the company’s level of maturity and other issues particular to each subject.  Therefore, it is difficult to provide any rules to go by, but if, for example, paid-in-capital seems excessive for a certain size company, it probably is and could indicate that the company requires more capital to operate than it has potential to generate revenue.  However, companies that require significant development or research dollars will often require significant paid-in-capital.

I hope that I have provided some general guidelines for analyzing a company’s balance sheet for possible red and green flags.  Like anything else, this is by no means a comprehensive guide, nor can the balance sheet alone provide a complete picture of a company’s financial health.  The balance sheet must be considered as a whole as much as it is an amalgamation of critical parts. 
 

Next time, Doug will take a look at the Statement of Operations ...

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