Most of what goes wrong at a public company is visible in its filings before it is visible in its share price. Not because anything is hidden — the disclosures are audited and the numbers are there — but because the informative parts sit in the notes and the cash flow statement, and attention goes to the headline.
Six checks, none requiring more than a few minutes, catch a substantial share of deteriorating situations.
1. Earnings rising while operating cash flow is not
The most reliable single indicator of earnings quality. Profit is an accounting construct built on judgments about timing; operating cash flow records money that moved.
The two should track each other over time. Any given quarter can diverge for legitimate reasons — a large payment landing either side of a period end. A gap that widens across four or six consecutive quarters is different, and it means profit is being recognised faster than cash is arriving.
Compare the two over a rolling twelve months rather than quarter by quarter, which removes most seasonal noise.
2. Receivables growing faster than revenue
If revenue rises 10 percent and receivables rise 30 percent, customers are taking substantially longer to pay. There are three explanations and none is good: credit terms were loosened to make sales, customers are struggling, or revenue was recognised on arrangements that will not be collected in full.
Days sales outstanding — receivables divided by daily revenue — expresses this in a form comparable across periods. A rising trend over several quarters is the signal.
Check the allowance for doubtful accounts alongside it. Receivables growing while the allowance shrinks as a percentage means management has become more optimistic about collection at precisely the moment the evidence suggests it should become less so.
3. Inventory growing faster than cost of sales
Goods are accumulating. Either demand disappointed, or stock was built deliberately — and a deliberate build should be explained. If the report does not explain it, the first interpretation is the safer one.
The composition note adds precision. A build in raw materials may be a supply hedge. A build in finished goods is completed product that did not sell, and it is the leading indicator of a write-down and of discounting to come.
4. Recurring “non-recurring” items
Nearly every company reports adjusted earnings excluding items characterised as exceptional. Some adjustments are entirely legitimate.
The test is recurrence. A restructuring charge in one year is an exception. A restructuring charge in each of five consecutive years is an operating cost being presented as an exception, and the adjusted figure is not describing the business.
Total the adjustments over five years and compare against cumulative statutory profit. Where the adjustments are a large fraction of the total, the adjusted series is the company’s preferred narrative rather than a correction for distortion.
5. Changes in definition
A company that introduces a new metric, changes how an existing one is calculated, or stops reporting one altogether is making a choice, and the direction of that choice is almost never neutral.
The pattern to watch for: a metric emphasised heavily for several years, then quietly dropped or redefined. The most common reason is that it stopped being flattering. Segment reorganisations belong in the same category — a declining division combined into a growing one ceases to be separately visible, and the ability to track its trajectory ends.
Comparing the metric definitions in this year’s report against those from two years ago takes a few minutes and is one of the higher-yield checks available.
6. Auditor and personnel changes
A change of auditor is disclosed and is usually routine. It is occasionally not, and the disclosure states whether there were disagreements on accounting matters. That statement is worth reading directly rather than relying on a summary.
The departure of a chief financial officer is a stronger signal, particularly an abrupt one, one without a named successor, or one shortly before a reporting deadline. The finance chief is the person with the clearest view of whether the numbers hold together.
Neither is evidence of wrongdoing on its own. Both raise the value of the other five checks.
Using them properly
These are screens, not conclusions. Each has innocent explanations, and a company triggering one in a single quarter is unremarkable. What matters is a trend sustained over several periods, and several flags appearing together.
They also say nothing about valuation. A company passing all six may be a poor investment at its current price, and one triggering several may already be priced for the deterioration. The checks identify whether the reported figures describe the business — a separate question from whether the business is worth what it costs.
Five of the six live in the cash flow statement and the notes rather than the income statement, which is the underlying point. We set out how to work through the first of those in reading a cash flow statement.
