Due Diligence: For investors with less accounting knowledge

Hello folks,

Would like to discuss some of the techniques you guys use for the rigorous due diligence.

Companies pays a hefty fees to accountants, and their consultants to find the minute loopholes in accounting to mask the reality. And, all of us are not accountants. Since, the auditors have lost their credibility, we can not trust them for a bit.
So, as a global investor, with average knowledge of accounting, how can we prevent ourself from such companies? How can we asses the quality of their reported numbers? How can we evaluate the quality of internal controls of the business?
I would like to know the red flags you guys looks, for the conviction that there is something fishy going on.
Some of the red flags I use are (Mostly from Financial Shenanigans book):

  1. Management hiding or just painting some different picture when some specific question asked.
  2. Unreasonably high margins/profitability, not backed by any source of competitive advantage.
  3. Indigestible capture of market share in short span of time, without any economic moat or in intense competitive market.
  4. Massive amount of capital stuck in WC
  5. Massive amount of cash not yielding anything or just sitting in fudgy banks.
  6. Capitalizing expenses with the intention to inflate numbers.
  7. Inspection of revenue sources
  8. Aggressive selling tactics being used?
  9. CFO/EBITDA - taxes being consistently below 80% or 120%, inventory levels, receivable levels, unearned revenue, aggressive revenue recognition policies, depreciation
  10. Negative owner’s earnings with consistency
  11. Unusual BOD
  12. Related party transactions
  13. Unusual compensation/incentive structure
  14. More and more efforts with intention to please the market
  15. Consistently reporting margins in line with market expectations (just hitting the bar)
    And, doing scuttlebutt to get more sense

Please continue and add ideas for not getting caught in trap…

  1. More than 15% of operating profit as remuneration to top management.
  2. Auditor resigning
  1. Big difference in remuneration of C-suite/senior managers and other managers (mid/low level)
  1. Extremely volatile margins over last 10 years
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One way I have seen promoters siphon out money from a listed entity is through the purchase of assets. For example, when a company has to purchase a fixed asset such as machinery or equipment, it is purchased at a higher price than normal, and the difference is paid in cash by the vendor to the promoter entity as commission. This is an unethical practice, and increases depreciation resulting in reduction of PAT while not affecting the operating margin. This sort of practice will however increase the asset base on the balance sheet, and thus compress the Return on Equity. While ROE can be compressed for a few years if there has been a large upfront capex, persistently low ROE is a red flag for me. So I personally try to avoid companies with low ROE for a prolonged period of time, especially if there are peers with higher ROE.