Five financial red flags and how to measure them
| Red Flag | What to Measure | Threshold |
|---|---|---|
| Revenue > cash collections | Accounts receivable days (DSO) | Growing 20%+ faster than revenue |
| Inventory > sales | Inventory days (DIO) | Building faster than sales growth |
| Estimate changes | Direction and frequency | Always boosting income = suspicious |
| Related-party transactions | Footnote disclosures | Undisclosed entities = red flag |
| Comp tied to earnings | Proxy statement | Heavy short-term bonus weighting |
Why red flags matter most in clusters
None of these indicators alone proves fraud. But when multiple red flags appear simultaneously — especially rising receivables AND estimate changes AND management turnover — the probability of manipulation increases significantly.
Inside the fraud triangle: opportunity, pressure, rationalization
The Fraud Triangle: Opportunity (weak internal controls), Pressure (earnings targets, debt covenants), and Rationalization. Most fraud is committed by people who never planned to be criminals.
| Triangle Element | What Creates It | What to Check |
|---|---|---|
| Opportunity | Weak controls, override authority | SOX 404 report, material weaknesses |
| Pressure | Miss estimates, covenant breach risk | Earnings patterns, debt ratios |
| Rationalization | Aggressive culture, CEO dominance | Tone at the top, whistleblower reports |
Compare revenue growth to receivables growth
Pull up a company in Fundamentals. Compare revenue growth to accounts receivable growth over 3 years. If receivables consistently grow faster, the company may be booking revenue it hasn’t collected.
Counting the red flags in a growth story
A retailer reports 15% revenue growth for 3 years, but receivables grew 40%, inventory grew 25%, and the CFO resigned. How many red flags?
Trust the numbers over the narrative
Recognizing the accounting-fraud warning pattern
You spot the following in a company's 10-K: (1) DSO rising from 45 to 72 days over 3 years, (2) inventory days up from 60 to 95, (3) two auditor changes in 4 years, (4) CFO turnover every 18 months. Disciplined reaction?
Check your understanding
Sit with the ideas.
A retailer reports 15% revenue growth three years running. But you notice: accounts receivable grew 40%, inventory grew 35%, and the CFO resigned unexpectedly mid-year. The company also changed its revenue recognition policy to be 'more aligned with industry standards.' How many red flags are present?
Why: