Learning to spot red flags before they cause damage is the most valuable skill. Classic red flags: (1) Revenue growing but cash flow declining — revenue manipulation. (2) Inventory growing faster than revenue — channel stuffing. (3) Receivables growing faster than revenue — quality issues. (4) Frequent auditor changes. (5) Complex subsidiaries hiding debt. (6) Promoter pledging increasing. (7) Unexplained 'other income' > 20% of profit. (8) Management selling while being publicly bullish.
Key points
Revenue growing but operating cash flow declining = #1 red flag
Inventory growth > revenue growth = channel stuffing risk
Receivables/Revenue ratio increasing = customers not paying
Auditor changes in consecutive years = major governance red flag
Promoter pledge increasing QoQ = financial distress
Management selling while talking bullish = credibility gap
Tax rate < 15% consistently = potential future liability
Formula
Cash Flow Credibility Score = Operating Cash Flow / Net Profit. Healthy: ratio > 0.8. Red flag: ratio < 0.5 for 2+ years. This would have flagged most major Indian frauds 2-3 years before blowup.
Warning — When multiple red flags appear simultaneously (rising pledge + auditor change + cash flow gap), exit immediately. Stocks that look 'cheap' after falling 50% on governance issues often fall another 50-90%. See: YES Bank, DHFL, Satyam.