How To Tell If A Company May Be Manipulating Its Earnings

As investors, it's important that we pay close attention to each company's cash flow. No matter how much the company may pad its performance figures - no matter how many bogus, intangible assets it creates on its books - it cannot create cash that's not there!

Follow the cash, and you'll almost always be a lot closer to the truth. And we've prepared a list of steps below to help you do just that. They are actually very easy for anyone with a knowledge of simple arithmetic. But your broker or financial advisor can also get the information for you.

If you're relying on faulty earnings information to pick stocks, you owe it to yourself to follow these 10 steps and hopefully avoid making a serious investment blunder. All it will take is a few minutes to calculate.

1. On the Internet, go to www,yahoo.com (listed in our "Links" section) and click on "Finance."

2. In the upper left-side of the screen, find the box "Get Quotes" and enter the ticker symbol of your company.

3. Immediately to the right of that box, you will find a pull-down menu. Select the item "Fundamentals" and press "Get Quotes."

4. In the box that appears, look in the column on the right labelled "More Info," and click on "Research."

5. Next, click on "Financials."

6. Then, click on the words "Cashflow Statement."

7. On the Cashflow Statement, find either the "Cash flow from operating activities" or "Cash flow from operations," and write that down. If it happens to be a negative number, like $20 million for instance, then right there you know that this company is not bringing in real money from its core business.

8. At the top of the page, click on "Income Statement," and find the net income for the current period. If this number is positive such as $10 million for instance, then it is not in sync with the cash flow that you just studied in Step #7... The company says it is making money, but the actual cash is going out the other way. And that gives you a second warning sign.

9. You could stop right here, but there are still a couple more issues that a good researcher should check into. Is this a significant discrepancy? Is it better or worse than some of the other stocks you're interested in? To answer these questions, click on "Balance Sheet" (also at the top of the page). About halfway down, find the most recent number for the company's "Total Assets," and write that down. Let's assume it's $100 million.

10. Subtract the net income from the cash flow. In this case it would be a negative $20 million minus $10 million, equaling a negative $30 million. Then divide that result by the total assets. In this case, it would be negative $30 million divided by $100 million, or negative 30 percent. That's not good. In fact, any company with a figure greater than 10 percent (whether negative or positive) is an indication of possible earnings manipulation. And the message these numbers are sending to you the investor is, Don't trust this company's earnings!

Is this approach infallible? NO. But no matter how quickly a company's earnings are going up, if cash flow isn't going up at the same pace, then something's fishy. If cash flow is consistently going down while reported earnings are going up, you can be relatively sure something's wrong!

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