What do these accounting red flags tell us about Frontier Developments (LON:FDEV)?

Uncertainty about a company's earnings or the way it reports its figures will inevitably weigh on the share price.

What most investors don’t realise is that there are algorithmic ways to check the credibility of company earnings - and one of them is called the Beneish M-Score.  Take Frontier Developments (LON:FDEV), for example, which develops video games using its COBRA cross-platform technology.

The Company is engaged in developing games of the strategy/simulation genre, including RollerCoaster Tycoon 3 for PC and Zoo Tycoon for Xbox. For the six months ended 30 November 2018, Frontier Developments PLC revenues increased from £19M to £64.7M and net income jumped from £2.9M to £15.4M. Impressive results at face value, but the M-Score flags up a couple of issues we might want to look into further.

It's important to note that this doesn’t mean that Frontier Developments is doing anything wrong. But it does mean that the risks could be higher than for other shares. As an investor, you should know what these red flags mean - both in Frontier Developments and any other stock you might be thinking of buying.

What the Beneish M-Score looks for...

Professor Beneish’s M-Score looks at the year-on-year change in eight different ratios that can be worked out from a company’s financial statements. It looks for these red flags:

• Inflated revenues
• Declining gross margins
• Capitalised and deferred costs
• Excessive sales growth
• Lengthening depreciation periods
• Rising sales expenses
• Increasing leverage
• Higher accruals

Ideally, you and I would want our stocks to be passing these checks with ease. But when a company fails one or more of them, it’s time to dig deeper into the accounts to find out why.

... And what it sees at Frontier Developments (LON:FDEV)

Here is a graphic that shows how Frontier Developments stacks up against the M-Score checklist.

These three "risk" areas indicate parts of the company it would help to look at in more detail before considering Frontier Developments as an investment.

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