How to Look at a Business Financial Statement and Know It's Time to Run

Back in 1999, Enron was a very successful and well-admired company. So was WorldCom. Of course, it all went right down the tubes shortly thereafter, and everyone invested in those companies lost their shirts. It could happen again. The only way you have as an average investor of protecting your interests, is to learn to study the business financial statement of each company with a view to identifying fraud. There are a things that you should learn to see as red flags. When you see those things, it's time to pack up and run.

Now it might seem overwhelming to you at first that middle-class investors should learn to read business financial statements and uncover fraud. Isn't that the kind of thing that genius Wall Street MBA types do? Well, just remember who uncovered Enron – it wasn't any Wall Street genius type. Those people losttheir shirts too. It was ordinary journalists at the Wall Street Journal. It was ordinary journalists armed with nothing more than a desire to know the truth. You could do the same thing just to keep your shirt.

Let's start at the beginning – what exactly is financial statement fraud?

Well, you know what it is – it's about finding ways to exaggerate revenuebasically. How do they do this?  Enron famously did this by recording future sales as if they were real current sales. Of course, they also tried to do the other thing – understate expenses. To do this, they took everyday operating expenses, and treated them like they were expenses made to buy machinery or something. They call it capitalizing operating expenses when companies do this kind of thing. There are a number of other ways in which they achieve their fraud too.

Basically, you're interested in learning how to uncover fraud in a business financial statement. There are a few basic ways. If the company seems to be surprisingly profitable on a consistent basis all of a sudden, you could look to see if the revenues have been growing as well while the cash flows remain stagnant. It's easy to show fictitious sales. It's more difficult to lie about cash flow.

If the company you're looking at seems to have very reliable sales growth while all its competitors seem to be gasping for air, you'll have to find out what makes your company this such a winner.

If they seem to have suddenly accumulated a lot of assets, that could be a bad sign too.

Of course, if this were as simple as allthat, anyone would be able to uncover these fraud. It can be quite challenging to really find something when a company is doing something fraudulent in real life.