There are many things to look for when analyzing financial statements. Often times the most revealing of these can only be found as the result of looking beyond the numbers to how the numbers relate to one another. This may sound technical and difficult, but it certainly does not have to be.Prebooking Sales
One of the most common ways to manipulate a company's books are to prebook sales. This often occurs when a company has weak sales throughout the year and needs to bump up its fourth quarter in order to meet shareholder and analyst expectations.
The practice of prebooking sales involves a business going out and contacting its regular customers and requesting that they purchase the inventory they are forecast to purchase in the next quarter now at a reduced rate.
An example: Company A always buys 500 widgets from our sample business every quarter at a fixed cost of $5 per widget. In order to show boosted sales in Q4 of the year Company A is convinced to purchase 1000 widgets at $4 today, accept deliver of the first 500 now, and the second set of 500 during the following quarter.
The net effect of this over the short term is that our company has doubled its sales- at least on paper. Over the long term though it has the opposite effect; unless Company A's needs suddenly increase dramatically they are going to cancel their order in the following quarter.The danger of prebooked sales
Prebooked sales are dangerous. If not managed correctly it is a fire that can grow wildly out of control. If the company prebooks sales now and follows that with a bad year the following year they may need to prebook sales again in order to meet last year's expectations, and then try and prebook other customers in order to meet growth expectations from investors and analysts. And so the spiral continues until eventually the company either can't find enough customers to prebook, or has so deeply discounted their margins that there is little or no profit left for the business.How to see prebooked sales in the books
There are ways to see when a company suddenly starts prebooking sales. Lets looks an example. Say that analysts had expected a business's sales to grow at 3% this year. Lets examine the following sales results by quarter.
2006 Q1
Q2
Q3
Q4
Total
$4,363,431.00
$4,799,774.10
$4,847,771.84
$5,574,937.62
$19,585,914.56
2007 Q1
Q2
Q3
Q4
Total
$4,494,333.93
$4,943,767.32
$4,993,205.00
$5,742,185.75
$20,173,491.99
2008 Q1
Q2
Q3
Q4
Total
$4,629,163.95
$5,092,080.34
$5,143,001.15
$5,914,451.32
$20,778,696.75
2009 Q1
Q2
Q3
Q4
Total
$4,768,038.87
$4,863,399.64
$4,912,033.64
$6,876,847.10
$21,420,319.25
As we can see the company did achieve the expected 3% growth in sales that analysts had expected. Numbers are hard to follow, a graphical representation of the change over the previous quarter may then be of some help.
We can see here that every year sales grow slowly throughout the year with Q2 and Q3 coming in very similar to one another. This last year though Q2 and Q3 come in weaker than expected and then suddenly Q4 jumps both off the trend from previous years and above what would be expected from the preceding two quarters. This looks suspiciously like prebooked sales.Results of Pre-Booked Sales
One of three things is going to happen when a company prebooks sales:
Think about each of these alternatives and the likelihood of each occurring. The house is fairly heavily stacked against you. Investing is hard enough, don't make it any harder.
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