There are lots of things that can go wrong with an investment, and that’s why it is sensible to have an investment checklist to go through before you buy any security. Below are some of the easiest things to miss and what should form part of a final checklist. It is far from an exhaustive investment checklist but should hopefully highlight any areas of concern before you invest, even if you have already analysed the company extensively as I do in my stock research.
1. How is their debt structured?
Lots of debt maturing at once is not good. Also high short term borrowing on variable interest rates is not good e.g. current bank loans. Long term debt is the best form, with staggered maturity dates. Check total debt maturity in each of the next few years and assess whether their cash flow is sufficient to allow them to refinance it or pay it off.
2. Besides debt, does the company have any off balance sheet liabilities?
This is usually in the form of leases but there can be other contingent payments. Good words to search for in the report are ‘contingent’, ‘contractual’, ‘commitment’ and ‘lease’
3. How is the number of shares changing over time?
Stock options are commonly issued to management and once exercised dilute the ownership per share. In the foot notes of the financial statements you can assess how much you are being diluted by each year. Make sure to also check the cash flow statement and see how many shares they have bought back in the year also which can mask dilution.
4. If there have been acquisitions/expansion, what do results look like on a pro-forma basis?
Acquisitions can increase sales, and mask a deterioration in the underlying business. Look for pro forma results or life for like sales to assess the strength of the underlying business
5. Do depreciation and amortisation adequately cover actual cash expenditure on property and intangible assets?
On the cash flow statement you should check whether depreciation is in line with cash outflow on property, plant and equipment (excluding expansion) and that amortisation is in line with acquisition of intangible assets. If they are not you should adjust profit accordingly.
6. Are accounts receivable days stable over time?
Accounts receivable days is calculated as Accounts Receivable / (Revenue/365), it approximates the average number of days buyers take to pay them for whatever they sell. If it is increasing over time it means they could be recognising revenue too soon, or not sufficiently accounting for refunds/bad customers.
7. Are accounts payable days stable over time?
Accounts payable days is calculated as Accounts Payable / (cost of goods/365) and approximates the days it takes them to pay an invoice. Big increases in this are a warning sign that their financial condition is deteriorating.
8. Is inventory accounted for under FIFO, or LIFO? (US only)
If FIFO, then care should be taken as management can boost earnings in the short term through inventory manipulation. The footnote on inventory should say which is used, LIFO is by far the most common.
9. Are inventory days stable over time?
Inventory days is calculated as Inventory / (Revenue/365) and approximates how many days worth of inventory they hold. Increases in this suggest a backlog of inventory is building which is not a good sign.
10. Are investments held for trading affecting operating cash flow
The main method of manipulating operating cash flow is through the purchase and sale of ‘investments held for trading’. Check the cash flow statement to see how much (if anything) such investments are affecting operating cash flow and decide whether they are actually ‘operational’ or an attempt to manipulate reported cash flow.
11. Are there any suspicious related party transactions?
Do a search for the term ‘related party’ in the annual report and read the paragraphs. If the company is doing a significant amount of business with a related party it can bring the strength of the business and integrity of management into question.
12. What do other analysts think of the stock?
This is a very important question to ask. Google phrases like ‘<Company name> fraud’ or ‘<Company name> buy/sell’ and you will find other opinion pieces. They can highlight things you haven’t considered or missed. Also search Google News for the company itself to find out the latest news. Don’t be swayed by the opinion of others, make up your own mind, but don’t ignore new information that you haven’t considered.
A final note on the Investment Checklist
It is worth reiterating, this is not an exhaustive list, it is merely an investment checklist to cover the most common pitfalls in investing and highlights the easiest things to overlook. It is a checklist I use myself before deciding whether to invest, and sometimes without specific searches for these things it is easy to miss them when reading an annual report. Download the annual report as a pdf and use the search function for some of the phrases noted above, like ‘contingent’ and you’ll be amazed to find things you had previously skimmed over.
My previous post on the Enron fraud gives a great example of how useful these simple checks can be to avoid a disastrous investment.If you found this post useful, please subscribe to receive new posts for free by email.
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