I'm no expert in spotting fraud, but I feel that a few simple things can protect most investors. The most important is a common sense check. If something appears too good to be true it probably is. If a company passes a common sense check I'll run some financial checks on it next. There are plenty of investment opportunities worldwide, if a company has a red flag or two and I'm uncomfortable I will move on. I don't need to waste my time trying to justify something questionable when there is another company just as cheap without the questionable items.
To show how an investor might evaluate a net-net for fraud I wanted to walk through an example with a stock I've talked about a lot recently Solitron Devices. I did this because a few readers mentioned that the frequent switch of auditors for Solitron was a massive red flag for fraud.
The way I'm going to structure this post is simple. For each check I did against the company there will be a header then a short description and then evidence for or against the specific check. I'm not going to conclude anything, I'll let the evidence speak for itself.
Establish the company is real
I don't believe establishing a physical presence exists and that a company does what they say they do is necessary for most investments. If fraud is going to occur (outside of China) it's usually a company fudging the numbers a bit, not a complete sham operation. But sham operations do exist so it's always good to check.
I have never visited Solitron so I can't vouch for their physical presence, but there is enough evidence on the internet that convinces me this is a real company. Starting from the most important to the least important.
Solitron is a government contractor and as such bids and contracts for work can be searched online. The search results include when the contract was opened, when it was fulfilled and the amount. The database contains a number of entries for shipped and completed orders to Raytheon a company Solitron names as a large client in their 10-K.
The company is subject to environmental violations related to past operations, the EPA is the monitoring agency. The EPA has detailed on-site visits with text and pictures describing what they found. The government is also getting paid a set amount from Solitron each year, if the government failed to receive what they were owed there would be litigation to reflect that, none exists.
A previous Solitron location is now a Superfund site, a lot of information regarding the site can be found here.
There is a company that will buy out out of production Solitron parts for resale.
The company has received an AS Accreditation.
Of course what's a company without employees. Salary and work environment information can be found here, here and here.
Large increases in inventory or receivables
Sometimes a company will inflate revenue by selling products without actually distributing them. A sign a company might be inflating revenue is if accounts receivable grows rapidly. The company sells products but doesn't collect the cash for the items sold, a major warning sign.
Here is the accounts receivable and inventory growth for the past five years:
Off balance sheet liabilities
A company can often make their balance more attractive by hiding liabilities off the balance sheet. One way of doing this is operating leases, other ways include special purpose vehicles, and joint ventures of dubious value.
Solitron has an operating lease that's clearly disclosed both in the 10-K and in an 8-K when they renegotiated the contract. I don't like operating leases, but if a company doesn't want to buy a facility they don't have many other options. I always include operating leases in my net-net worksheets.
Impairments or write-downs
A company that makes bad capital allocation decisions ends up writing down the balance sheet value of assets they had acquired in the past. Solitron as far back as I looked hasn't recorded any impairments.
Cash flow tracks net income
Outside of timing differences net income should track operating cash flow very closely.
A second way of looking at this CFO/Net Income:
Excess cash margin
This is a formula from the book Creative Cash Flow Reporting that is: CFO - EBIT / Revenue. The book discusses it in detail but the idea is the excess cash margin should be slightly positive. A negative margin indicates that net income could fall in the future.
Items accrued on the balance sheet are a result in timing differences between cash and accounting entries. For example an expense might be incurred yet not paid out in cash during a specific period. Management can use accrual entries to artificially inflate profit or lower expenses. As a general rule lower accruals indicate higher quality earnings.
There are many other financial statement quality checks that can be completed but at this point I think there is enough evidence for a reader to make a determination on their own.
Talk to Nate about this post.
Disclosure: Long Solitron Devices