The most important thing for investors is not to lose money. As Warren Buffett once said:

“The first rule of an investment is don’t lose money. And the second rule of an investment is don’t forget the first rule. And that’s all the rules there are.”

Buffett means that investors should first focus on the downside of any investment instead of the upside (which is not what most of us do). Essentially, it is more important for Buffett to invest in a company with minimal bankruptcy risk over one with a small chance of 100x upside.

Investing in companies with fraudulent accounting statements is a common way to wipe out your investment savings. Unfortunately, accounting fraud is all too common even in the 21st century. Buying a stock like Enron, unaware that it was a fraudulent time bomb waiting to blow up, can lead to disastrous results. Just look at the stock’s price chart:

Luckily, there are a lot of tools investors can use to spot red flags on financial statements, which we are going to delve into today.

In this post, investors will learn about four financial statement red flags:

• Large accounts receivable balances
• Hiding variable costs in operating expenses
• Poor cash flow conversion
• Rising levels of complexity and opacity

Large accounts receivable balances

This is the definition of accounts receivable:

“The balance of money due to a firm for goods or services delivered or used but not yet paid for by customers. Accounts receivable is listed on the balance sheet as a current asset. Any amount of money owed by customers for purchases made on credit is AR”

Simply, it is an asset on the balance sheet that tries to estimate the difference between the revenue a company states it has earned vs. the cash it has actually collected from customers.

An accounts receivable balance is necessary for most businesses. Customers may pay 30, 60, or even 90 days after receiving a product depending on how a company collects cash. This means the business will record an item as “revenue” even though the cash has not been collected.

Having an accounts receivable balance is not nefarious. But there are plenty of ways management teams can manipulate accounts receivable to make revenue look higher than it should be.

Management teams may decide to log a long-term contract as upfront revenue even though accounting standards dictate that the revenue should be recognized over the entire life of the deal. They may also book revenue on a contract that has not been officially signed, reducing the chance that a customer actually pays for that revenue.

Even more aggressive tactics include double booking a contract or outright faking deals.

These were tactics used by Oracle in the 1980s and early 90s. The company eventually ran into trouble, had to pay millions in fines, and saw its stock plummet. Most investors were unaware of this and were caught off guard by the scandal. But smart investors could have seen it coming.

How do you find a suspicious accounts receivable balance on a stock’s financial statements?

Look for a high accounts receivable as a % of revenue and/or an accounts receivable balance that is growing faster than revenue.

A growing % of revenue that comes without actual cash collection is a red flag that investors should pay attention to when analyzing a stock.

Hiding variable costs in operating expenses

When analyzing an income statement, it is important to look at what expenses come from variable vs. fixed costs. This is a basic accounting concept that you will learn in Accounting 101.

Variable costs scale with revenue while fixed costs are, well, fixed no matter how large your revenue is. Looking at the difference between fixed and variable costs can help determine the potential operating leverage for a business and how high its bottom-line margins can get.

A business with minimal variable costs, such as Visa, can have bottom-line net margins above 50% and extremely high gross margins. A company such as Wal-Mart or Costco with high variable costs will have low gross margins and low net income margins.

Nefarious management teams are incentivized to boost the stated gross margin on the income statement to make it look like their businesses have better unit economics than in reality. Investors will give these stocks a premium valuation due to the theoretical margin expansion potential for a high gross margin company.

A red flag for investors is when a company hides what should be variable costs in the operating/fixed cost line items on the income statement.

For example, back in 2020 and 2021, Peloton recorded payment processing fees as an operating expense when in reality this is a variable cost that scales with revenue. Smart investors can spot this and understand that Peloton was giving out a misleading gross margin on its financial statements.

Unsurprisingly, Peloton stock is down over 95% from its highs. If you find an example of blatant accounting shenanigans at a company, it is a red flag worth considering before making an investment. If the company is okay with misleading investors once, why would it not be comfortable doing it again?

The good news is that companies must publicly disclose where they are categorizing their expenses on every annual report. Crack open a stock’s investor relations page or the EDGAR SEC database, download the annual report of a stock you own and see what these definitions are for yourself. You might find some surprises.

Poor cash flow conversion

Net income at the bottom of the income statement is not the actual cash collected by a business over a certain period. As we saw with accounts receivable, there are estimates a company has to make regarding revenue recognition along with non-cash expenses such as stock-based compensation when filing financial documents with regulators.

Over time, net income should equate with the cash flow a business generates, excluding stock-based compensation for employees. Otherwise, the stated net income is misleading investors. At the end of the day, all that matters is the excess cash a company generates that can be returned to shareholders through dividends and share repurchases.

A common red flag for investors is when cash flow is consistently well below net income. Of course, a growing business may invest heavily in capital expenditures to grow, which will suppress cash flow in the near term. But as the business matures, net income should start converging with cash flow. Otherwise, that net income is inflated.

Enron is a major example of stated net earnings misleading investors. The company used multiple fraudulent accounting tactics to artificially inflate earnings even though its cash pile was drying up. These included poor mark-to-market contract accounting, hiding expenses and debt off the balance sheet, and the accounts receivable tactics discussed above.

Once this accounting fraud was exposed, investors realized the company was running out of money and way less profitable than it indicated on its financial statements. Smart investors who look at cash flow conversion could see a smoking gun that would have kept them away from this stock.

If a company consistently generates less cash than its stated net income, you should be skeptical of that net income figure. Not only is this a smoking gun for accounting fraud, but can indicate a low-quality business. You don’t want to invest in low-quality businesses, right?

All else equal, businesses that fail to convert net income into cash flow are worse than ones that consistently generate profits. Poor cash flow conversion is a red flag that investors should consider before investing in a stock.

Rising levels of complexity and opacity

My last red flag is a general lesson that can be applied across financial statement analysis.

As a rule of thumb, you want to avoid companies with complexity and opacity in their financial documents. The more complex financial documents are, the easier it is for you to miss something nefarious. The more opaque financial statements are, the more likely a company is hiding something nefarious from you.

Simple.

Complexity can rear its head in changing revenue recognition, segment/profitability metrics, intricate debt structures, and many other ways. In other words, a management team may make its financial documents so long, confusing, and dense that they believe no investor will truly understand what is going on with the business.

An easy way to gauge this is the length of an annual report. Costco – a company with top culture and accounting practices – has a 76-page annual report. Chinese electric vehicle maker Nio has a 503-page annual report. Which one do you think is more likely to mislead investors through complexity? Obviously, it is the one over 500 pages.

Opacity is the opposite diversion tactic. This is when a management team does not disclose information it should to investors. Nefarious management teams may fail to answer questions about certain business trends or key performance indicators (KPIs) when asked by an analyst or fail to properly disclose business developments with the SEC.

A form 8-K is an SEC filing that a company will file when an unscheduled material event has occurred for a business. This could be winning or losing a major client, a change in management, or a new debt offering with a bank.

Devious management teams will sometimes not file 8-Ks on new material developments when the business update is negative for the business and could lead to a falling stock price. If a management team does this, it is an example of being opaque with investors and should be a red flag for any stock shareholder. Sadly, it is far too common a management tactic today.

Ultimately, investors want to avoid buying stocks with devious management teams trying to make their businesses look better than they actually are. Using historical examples and our accounting knowledge, we can try to mitigate these risks when buying stocks for our investing portfolios.

Remember Warren Buffett’s first rule of investing: Do your best to avoid investing in fraudulent companies. This will help you avoid losing money on your investments.