Red Flags & Accounting Warnings

Introduction

Good analysis catches problems before they hurt your portfolio. This lesson covers red flags and the accounting signals that deserve extra scrutiny.

Earnings vs Cash Flow

A key warning:

Profit much higher than operating cash flow, persistently
-> revenue or earnings may be low quality

Revenue Quality Signals

Watch for:

• Receivables growing faster than sales — sales may be booked but not collected
• Inventory piling up — products may not be selling
• Aggressive revenue recognition — recognizing sales before they're earned

Accounting Disclosures

• Frequent auditor changes — can signal disagreement or pressure
• Related-party transactions — possible self-dealing
• Complex, opaque structures — harder to audit and understand
• Large one-off gains dressing up otherwise weak results

Management Signals

• Excessive optimism or vague answers on calls
• Frequent M&A that looks like empire-building
• Insider selling at large scale (though not always negative)

The Big Warning

The strongest overall warning: numbers that look too good for too long without details to back them up. If you can't understand how the money is made, be very careful.

What To Do

• Treat flags as triggers for deeper digging, not instant verdicts
• Cross-check reported numbers against cash flow and disclosures
• When in doubt, size down or avoid

Summary

• Profit far above cash flow is a warning
• Watch receivables, inventory and revenue recognition
• Frequent auditor changes and opacity are red flags
• One-offs can flatter reported results
• When you can't understand the numbers, be cautious

Next Lesson

Putting a number on it: valuation methods.