Applied analysis
Red flags in financial statements
Spot the warning signs — receivables outpacing sales, inventory build-ups, capitalised costs, falling cash backing — and test Rawdah for them.
Learning objectives
- Name the common warning signs in the income statement, balance sheet and cash flow
- Calculate growth gaps and cash-backing ratios that flag them
- Explain how capitalising costs flatters EBITDA and CFO but not free cash flow
Most accounting problems don't start as fraud. They start as optimism: revenue booked a little early, inventory that won't sell at full price, costs treated as investment. The statements still add up, but profit runs ahead of economic reality — and eventually of cash. A red flag is a pattern that makes this more likely. It isn't proof; it tells you where to dig.
The most reliable flags compare two numbers that should move together:
| Red flag | What it can mean | Test |
|---|---|---|
| Receivables growing faster than revenue | Looser credit terms, sales pulled forward, uncollectable balances | Receivables growth − revenue growth; DSO trend |
| Inventory growing faster than COGS | Over-buying, slow-moving or obsolete stock not written down | Inventory growth − COGS growth; DIO trend |
| CFO persistently below net income | Profit made of accruals, not cash | CFO ÷ net income; accruals ratio |
| Capex far above depreciation, rising intangibles | Operating costs capitalised (or genuine expansion) | Capex ÷ D&A; capitalised costs in the notes |
| Recurring "one-off" charges | Normal costs presented as non-recurring | Adjustments appearing every year |
| Changes in estimates or auditors | Useful lives lengthened, provisions released, disagreements | Accounting-policy and audit notes |
Receivables gap = g(Receivables) − g(Revenue) Inventory gap = g(Inventory) − g(COGS) Cash backing = CFO ÷ Net income
- g(x)
- year-on-year growth: xₜ ÷ xₜ₋₁ − 1
- gap
- persistently positive gaps mean the balance sheet is absorbing a rising share of sales or purchases
- Cash backing
- for a company with meaningful D&A, normally above 1.0x
Calculate
Rawdah's trade receivables rose from 79.7 to 102.5 in FY2025, while revenue rose from 1,386.0 to 1,497.0. By how many percentage points did receivables growth exceed revenue growth? Give a percentage to one decimal place.
Check your understanding
A retailer capitalises SAR 10m of store pre-opening costs into PP&E instead of expensing them. Compared with expensing, what happens in the year the costs are incurred?
Challenge: a red-flag screen for Rawdah
Build a screen that flags warning signs automatically.
- Rows 13–14 (FY2024–FY2025): receivables growth − revenue growth, and inventory growth − COGS growth.
- Rows 15–16 (all years): CFO ÷ net income and capex ÷ D&A.
- Rows 17–19: return "FLAG" or "OK" with IF — a growth gap above the threshold in B10, or cash backing below the threshold in B11, is a FLAG.
| A | B | C | D | |
|---|---|---|---|---|
| 1 | SAR m | FY2023 | FY2024 | FY2025 |
| 2 | Revenue | 1,240.0 | 1,386.0 | 1,497.0 |
| 3 | Cost of goods sold | 719.2 | 810.8 | 890.7 |
| 4 | Trade receivables (year-end) | 61.2 | 79.7 | 102.5 |
| 5 | Inventory (year-end) | 187.2 | 226.6 | 268.4 |
| 6 | Net income | 105.9 | 98.1 | 95.2 |
| 7 | Cash from operations | 128.7 | 92.8 | 83.0 |
| 8 | Capital expenditure (cash paid) | 62.0 | 85.0 | 96.0 |
| 9 | Depreciation & amortization | 38.0 | 42.0 | 47.0 |
| 10 | Flag a growth gap above | 5.0% | ||
| 11 | Flag CFO ÷ net income below | 1.00x | ||
| 12 | Warning signs | |||
| 13 | Receivables growth − revenue growth | |||
| 14 | Inventory growth − COGS growth | |||
| 15 | CFO ÷ net income | |||
| 16 | Capex ÷ D&A | |||
| 17 | Flag: receivables | |||
| 18 | Flag: inventory | |||
| 19 | Flag: cash backing |
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