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Spot Hanky Panky with Cash Flow Analysis

Although it’s no secret that some companies have cooked their books, you can spot signs of questionable bookkeeping before the results or subpoenas are served.

Company books are never cooked evenly—at least some of the numbers are real. It’s more like they’ve been microwaved for a few minutes on high rather than baked at 325 degrees until done to perfection. Perhaps the most egregious example of this is Enron, whose saga, along with its master chefs Lay, Skilling, and Fastow, has been beaten to death in the financial press. For all the coverage, hard analysis of the numbers has been hard to find. By putting financial statements under the microscope, you have a chance to spot suspect numbers and cash out of investments whose accounting practices are questionable. Analyzing Enron’s and WorldCom’s financial statements can help you learn what to look for—and avoid.

Earnings are the obvious number to cook, because that’s what the market pays attention to. A good place to start hunting for numbers that don’t make sense is the balance sheet: a statement of a company’s assets, liabilities, and shareholders’ equity. The tenacious financial chef can make balance sheets lie, but companies rarely fudge their balance sheets because Wall Street simply doesn’t pay that much attention to them. For that reason, you have a better chance of uncovering the truth about a company’s cash flow by comparing successive balance sheets to determine where the money came ...