In this article, we will answer one of the Foolish questions asked by one of our readers. He asked (quoted verbatim) –
“How to effectively read annual report and detect the financial gimmicks and evaluate management integrity precisely?
Owner’s earning = Net income + depreciation + amortisation + non cash charges – capex and including adjustment for working capital… How to adjust working capital effectively?”
There are some ways to detect financial gimmicks. Compare the revenue increase with the trade receivables increase year-on-year. If the trade receivables have increased at a higher percentage than the revenue increase, it may be a potential red flag. This may mean that the company is booking revenue aggressively. If the profit of the company increases year-on-year, the Cash Flow from Operations should also increase in line. To learn more, you may also refer to a comprehensive book called Financial Shenanigans: How to Detect Accounting Gimmicks & Fraud in Financial Reports by Howard M. Schilit to learn more. The book covers earnings, cash flow and key metrics fraud and how to discover them.
For the second part, the reader asked how to evaluate the integrity of management precisely. I am unsure about the “precisely” part but at least, one can evaluate management to a certain extent. One of the ways to evaluate management is to read the annual reports and scrutinize the Chairman’s Statement, the percentage of insider ownership, and the remuneration package of the management.
When reading the Chairman’s Statements, look out for candidness of the Chairman. Does he accept mistakes that happened in the past or does he sweep it under the carpet? Reading at least five years of Chairman’s Statements helps. Also, look out if promises by the management are delivered. If the company said that it would explore a new business opportunity two years ago, do ensure that the promise is kept.
Next, look at the percentage of ownership of the company by the management. If the management owns a huge part of the business, we can be assured that the management’s decisions will be aligned with that of the shareholders. The Chairman of companies such as Raffles Medical Group Limited (SGX: R01), ARA Asset Management Limited (SGX: D1R) and Boustead Singapore Limited (SGX: F9D) own huge percentages of their respective companies, all upwards of 30%. In fact, Dr Loo Choon Yong, the Executive Chairman of Raffles Medical Group, owns 52.3% of his company.
The annual report will also contain a section on remuneration of the management. Check that the management is not paid exorbitantly high amounts of money. This can be done by cross-checking the compensation with that of the competitors of the company.
Now let’s look at the last part of the question on adjusting working capital effectively. Owner’s earnings, as defined by Warren Buffett in his 1986 Shareholder’s Letter is:
“These represent (a) reported earnings plus (b) depreciation, depletion, amortization, and certain other non-cash charges…less (c) the average annual amount of capitalized expenditures for plant and equipment, etc. that the business requires to fully maintain its long-term competitive position and its unit volume….
Our owner-earnings equation does not yield the deceptively precise figures provided by GAAP, since (c) must be a guess – and one sometimes very difficult to make. Despite this problem, we consider the owner earnings figure, not the GAAP figure, to be the relevant item for valuation purposes…All of this points up the absurdity of the ‘cash flow’ numbers that are often set forth in Wall Street reports. These numbers routinely include (a) plus (b) – but do not subtract (c).
The formula to calculate the changes for working capital = (Year 2 Current Assets – Year 2 Current Liabilities) – (Year 1 Current Assets – Year 1 Current Liabilities). This is simply the difference in working capital between two different periods.
Warren Buffett once opined that, “In evaluating people, you look for three qualities: integrity, intelligence, and energy. And if you don’t have the first, the other two will kill you”. A dishonest management will be more concerned about dressing up the financial statements for short-term gains. Our dear reader, you certainly are going in the right direction in your thirst for knowledge to uncover financial gimmicks.
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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Sudhan P owns shares in Boustead and ARA Asset Management.