When a seemingly good company losses its gains over the years, the question is could have you have seen this coming? or what were the red flags? According to David Milstead’s column finding the red flags in a firm’s financials published in the Globe and Mail August 20, it is actually harder than it looks to be. Mr. Milstead examined 2 companies which a third company Veritas places companies puts on an an Accounting Watchlist when Veritas has concerns over the financial reporting.

The problem with accounting is although it should be reasonably black and white, in accounting there are many grey areas which companies go into. Veritas is a company which tries to state what public companies are into the grey area.  According to the CEO of Veritas  – When you find accounting issues, it alerts you to a divergence between what the business economics are doing and what the financial statements are telling you. If the business economics improve, then it does not matter the financial statements were managed. If the business operations continue to erode, then you can not play with the numbers any more.

The first case was Avigilon – it sells security cameras and it reported its gross profit margin fell from 58% to 50%. The reason the margin fell was the company lower the prices on its cameras in an effort to sell more of them or capture a greater market share. On itself the lowering of prices may not be a bad thing, however when the CEO leaves, the people change in the department as well as changing auditors – they all tend to be a red flags, because it asks the questions why the changes?

Avigilon sells cameras to distributors who sells them to the public. Inventory turnover and accounts receivable need to be carefully watched. The company says it is trying to get into the entry-level market in order to grow which leads to other concerns. do they have the capabilities to go into the entry-level market? how much of the market would they need to capture? how will the competition respond? and the list begins to build.

The other company Mr. Milstead  wrote about was CGI group who came under watch through an acquisition in Europe called Logica. The European company was bigger than CGI and the issue was purchase price allocation. The concern is reporting income twice and the test is to focus on the cash. When contracts are renewed at what margin are they reported at – CGI or Logica? over the past couple of years it turns out to be CGI and the company is no longer on the accounting watch list and the stock is doing well.

Veritas and you should watch the alignment between the earnings that is reported and the cash flow which is generated. Remember cash flow pays bills.

Linking to dividend paying stocks, most of the time you do not have to worry whether the companies are not making profits because they have been consistent over time. However economies and commodity cycles do happen; if you know what the company does and how it makes money, then you will have fewer concerns unless the world’s economies all decline together. Fortunately that does not happen often and when it did the best performing companies on the rebound were profit making companies.

There are more questions than answers, till the next time – to raising questions.