Saturday, March 22, 2014

Interpreting reports #1: Revenue & the importance of accuracy

Revenue is the lifeline of any business in the world. Unfortunately many companies end up making it look better by "managing" the financials. In this blog I would like to cover some of these technical aspects of sound investing. Detection & correct economic interpretation is the biggest strength of the astute investor and the easiest determinant of inflated revenue numbers is comparing cash flow from operations (CFO) to net income. Of course creative accounting can doctor CFO itself and we need to protect against that as well. In an ideal simple company cash flow from operations should be net income + depreciation assuming that the customer and vendor transactions are done on time, the customer and vendor payment terms are the same and inventory is being managed well.

Overstatement of revenue can be done in many ways some of which are:
  • Creating the invoice without having the customer's consent
    • Cases where this can happen: 
      • invoicing before shipment
      • Shipping goods/services without the customer wanting them
      • Backdated contracts or early revenue recognition on a contract
    • Losses: Leads to tax losses if the customer does not accept it in the future as invoices cannot be cancelled at will. There are several laws at play.
    • Detection: CFO vs net income.
  • Recognizing revenue before shipment/customer quality approval
    • Detection: Large increases in un-billed receivables.
  • Invoicing/recognizing 100% of value when <100% of the costs have been incurred
    • Detection: CFO vs net income. Secondly revenue recognition should be done after all the costs have been recognized. Read the revenue recognition policy in detail. Also look for previous quarter costs shown as 
  • Rejected goods lying with customers pending for rejection
    • Detection: This is very hard to detect and needs to be determined by looking into the history of customer claims, warranty claims, old rejections, etc. from the statements. 
  • Wild customer payment terms:
    • Increasing payment terms from 2 weeks to 6 months might increase sales drastically for customers but leads to interest loss, high recovery risk etc.
    • Detection: Debtors % of sales should be around 8% ideally - this shows a 30 day healthy payment cycle
  • Creditworthiness of customers
    • Detection: Very hard to determine but generally I try to avoid companies with higher than 15% debtors % of sales. Try to also avoid large credit exposures of the company to single customers - anything over 15% with a single customer is a company to stay away from. In addition to credit risk this will cause too much negotiation power with a single customer. For capital goods and long term service providing contracts customer financing situation needs to be studied. Again data on this might be scarce but needs to be dug out.
  • Sales to affiliates and group companies
    • Typically group company revenue is subtracted out but for example sales to the overseas or local parent might be done on varying payment terms and costing.
    • Detection: Unfortunately no annual report is going to say I sold for cheap and with a 6 months payment term to my majority shareholder's private firm. So the best tools we have are debtors% of sales and CFO vs Net income
  • Barter or stock transactions with customers:
    • For a detailed account on this please read the Financial Shenanigans book listed in the references but sometimes barter transaction values maybe inflated and revenue recognized.
    • Detection: Read the financials, annual reports, news and media releases carefully for this action.
  • Revenue recognition policy - needs to be deeply and carefully read by the investors to see if something does not sound right to you.
  • Revenue can be "managed" by with-holding revenue recognition for future quarters
    • Detection: Recognition of revenue from old work done, large margin changes across quarters or years without fundamental reasons. Large CFO vs Net income changes across quarters or years.
  • Marking up inventory at "maximum retail price" as it is in the finished goods yard or a fictitious completed service bucket
    • This may not be the sales price. Typically this reduces the cost side but in some creative cases it can be used to affect revenue as well. 
    • Detection: Read the inventory valuation sections carefully. Large negative adjustments to CFO due to increased inventories when payable's are not rising.
  • Cash flow from operations can itself be changed by wrongly recognizing investing cash flow as operational cash flow. Sometimes such transactions can be recognized as revenue as well so that the CFO and Net income are not too off from each other
    • Detection: Careful reading of the statements
So as we know there is no replacing careful reading of the information being given out by the company - annual reports, quarterlies, news releases, information given to the exchange, etc.

Keep a lookout for this space for more on how to be careful while reading financials & reports.

References

Financial Shenanigans by Howard Schilit