This article is authored by Quim Abril, founder and portfolio manager of Global Quality Edge Fund, based in Barcelona.
To start, we define a “red flag” as an accounting risk that may jeopardise a company’s future earnings as well as their expected cash position. There are many types of ‘red flags’ but the key will be in finding those that are most meaningful.
To avoid falling victim to them, it is always best to thoroughly read through annual filings; even though these will not always be easy to grasp and at times will require a certain background in accounting to fully understand them. Mastering them is not always easy. As time goes by, company reports continue to grow in length, new accounting practices are released almost every year which make their interpretation a constant challenge for the reader.
Red flags will become more frequent in nature at a time like now, when the economic cycle of the U.S., for example, is coming to an end and companies may struggle to continue growing their earnings at the same rate as they did before. Under this scenario, senior management could find itself ‘motivated’ or ‘incentivised’ to apply more aggressive accounting rules to maintain earnings per share and cash flow. It is then our job to see if we’re facing a potential risk and understand if the underlying figures are cast into doubt by the ‘red flag’.
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