Hudson Labs uses artificial intelligence to read financial text, understand its meaning and assess its importance. We use state-of-the-art text processing to identify narrative information that is predictive of fraud, malfeasance and earnings management. Our models do not rely on key words but rather assess relevance and importance based on the underlying meaning.
Hudson Labs red flags tend to fall into a few broad categories. Below, we break down Hudson Labs' primary red flag categories and explore how each of them is indicative of downside risks.
Cash flow, credit & capital
Cash is the lifeblood of all businesses. Liquidity risks increase the pressure on management teams and therefore the risk of earnings management. Struggling companies can seek cash funding in various ways: private placements from related parties, loans from distressed debt investors, or factoring receivables. If it is clear that a company will not survive due to cash shortage, it will disclose that it has a substantial doubt in continuing as a going concern.
Independent accountability mechanisms are necessary to keep a company on track through the good and bad times. Excessive founder control, insufficient expertise, poor compensation structures, and non-independent boards are all factors that increase the risk of both malfeasance and general poor performance. Governance matters even more at large, established companies. Learn more about governance and it's impact on price.
Internal controls are processes performed by management to ensure that the company’s financial information is accurate. Companies that report issues with their internal control processes are at a higher risk of misstating their financials and, on average, have notably higher fraud risk. Learn more about internal controls and material control weaknesses.
Legal & regulatory
Misery loves company, seemingly unrelated legal and regulatory issues tend to correlate with the risk of fraud. Bedrock AI surfaces legal and regulatory red flags covering everything from FDA warning letters to environmental lawsuits to DOJ and SEC investigations.
Accounting is anything but black and white. It is impossible to accurately evaluate a set of financial statements without understanding the policy choices, judgments and estimates that went into financial reporting. Companies that frequently change policies, rely on aggressive assumptions or frequently change presentation (e.g. change segment disclosure every year) are less worthy of your trust as an investor. Learn about major accounting estimate changes at tech companies in 2022.
Revenue, accounts receivable & customers
For many companies, revenue is the most important financial line item and also a common target for manipulation. Excessive dependence on key customers, pulling forward sales from future quarters and changes in estimates and policy all have an impact on revenue-related risk factors. The new accounting standard, ASC 606 has increased the subjectivity involved in accounting for revenue, increasing the opportunity for manipulation.
Management turnover (Resignations & dismissals)
Frequent turnover at the top is often a symptom of more serious underlying problems.
Despite criticism of the SEC and other institutions, the United States has the most robust capital markets oversight infrastructure of any country in the world. Jurisdictional risk is real. Companies that are domiciled abroad or operating abroad are subject to varying degrees of increased risk related to accountability, corruption, repatriation, transparency and more.
Operations & strategy
Frequent changes to company strategy can indicate that the management team is chasing hype rather than focusing on fundamentals. Operational red flags like product recalls, supply chain issues etc. can also indicate mismanagement, and as noted above, misery loves company.
Related parties, conflicts & other relationships
Related parties are people or organizations that are affiliated with the corporation or management team in some way. From Enron to Luckin to Sino-Forest, related parties played a role in some of the world's most famous fraud scandals. Transactions with related parties are typically not executed at arms-length (i.e., transactions in which the two parties act independently in their self interest.)
Mergers & acquisitions
Many large corporations commit to M&A transactions in order to grow their businesses. However, it may be a red flag if the company relies on M&A in order to grow its revenues. If there is no organic growth in a company’s existing business operations and it’s clear that management prioritizes M&A for its growth instead, that is a major red flag.
Bankruptcy red flags primarily relate to bankruptcy risk or real bankruptcy among customers, subsidiaries or other related parties.
Buzzwords & jargon
Fraudsters often overuse buzzwords and jargon (yes, like "Artificial Intelligence" but we promise we're for real). Watch out for sentences that use flowery language but in essence mean nothing.
Compensation & corporate perks
Watch out for CEOs who spend a lot of personal time on the corporate jet. Excessive corporate perks can be a red flag but under-compensation or absence of cash compensation can also be a red flag. Executives who are not appropriately compensated often feel more pressure to meet bonus goals and feel more justified in using corporate assets for their personal gain.
Impairment indicates that the long term prospects of a company’s performance and growth has been negatively affected. The value of long-term assets in a company’s balance sheet, such as equipment, buildings, or goodwill, represent future economic benefits of the company. If these assets are impaired, the company believes that they will no longer reap economic benefits from those assets. Impairment can be a harbinger of bad news to come.
Non-GAAP metrics, exclusions & one-time charges
Non-GAAP metrics such as adjusted EBITDA may be easily manipulated by management. Such metrics may be tied to incentive-based compensation plans for executives. These metrics can and are used to deceive investors and often imply that costs that are in fact recurring won't be repeated in future years.
Examples of off-balance sheet items are lines of credits and pending litigation costs. Although these are not debt in the balance sheet, they might end up becoming severe burdens to the company later on. Enron famously collapsed due to risks that weren't recorded on the balance sheet.
Reserves, accruals & allowances
Determining reserves, accruals, and allowances in accounting is often highly subjective and an easy target for manipulation. Look out for aggressive reversals and insufficient allowance accounts.
There is a lot of estimation and management judgment in determining tax-related financial line-items. Deferred tax assets and the associated valuation allowances can be used for earnings management. For example, a company can increase its net income by reducing its valuation allowance for deferred tax assets.