“If we avoid the losers, the winners will take care of themselves.” Howard Marks
Before investing our hard earned money in any stock, and thinking about how much we could potentially earn in an investment, we should first think about the potential downside of it. The good news is that we can easily spot companies that may be risky by just looking at their financial report.
Here are the 7 red flags that all investors should be able to spot when looking at a company’s financial health.
1. Declining Earnings
The business environment is full of uncertainties and competition. Companies may at times face challenges that cause declines in quarterly results, such as oil price fluctuations, currency fluctuations and economic slowdown.
However, investors should beware when the problem persists and companies consistently report declining profits and margins over a substantial period. It could mean the company is losing its economic moat and capability to compete in the market.
A company that have declining earnings may also eat up its cash and cash equivalents. Investors should compare its amount of cash and cash equivalents with its past records. The company might also raise more money by rights issue and debt financing.
2. Too Much Debt
Debt is good for a company when it is used appropriately. A company could often borrow money to fund their operations and investments instead of using shareholders’ equity. This allows companies to achieve much higher returns on equity and make bigger investments for the future.
However, too much debt can be dangerous for a company. A company may not be able to pay up its debt and go bust when there are any unforeseen circumstances such as economic crisis.
Besides, a large amount of debt could cost a lot for a company. A company’s income statement shows how much does it pay to service its debts. As an investor, we would not want our company’s earnings eaten up by its huge finance cost.
Some companies which fall under this reign are the Oil and Gas companies like Ezra (SGX: 5DN) and even commodity trader Noble Group (SGX: CGP).
3. Negative Cashflow
Cash flow is the amount of cash and cash equivalents entering and leaving a company. A company might make lots of revenue and profits but has a negative cash flow.
Cash is the lifeblood of a company. Therefore, companies need to be able to generate cash consistently over time. A company that unable to generate cash in the long-term will face severe cash flow issues over time.
Besides, having cash on hand also means the company will be able to make investments in the future and can expand its business if it chooses to do so.
4. Dividend Cut
Only companies that are profitable and continuously generating positive cash flow could afford to payout stable dividend every year.
Companies might reduce, or eliminate, their dividend payments to shareholders when management needs money to expand its business or the company is facing tough times.
When companies go through tough times, dividends are usually one of the first items to go. It’s important for investors to investigate further whether the dividend cut is a signal of a company facing headwinds.
Investors could watch out for declining profitability or a negative free cash flow as a potential red flag.
5. Switching Auditors
As we all know, public companies must have their financial statements audited by an outside accounting firm.
It is common for companies to switch firms from time to time due to 3 main reasons:
- Company size/model has out-grown beyond the capabilities of the old audit firm
- Looking for an auditor that would charge less.
- Prove to shareholders on the due diligence of the company
However, an unexpected and sudden change of an auditor or accounting firm for no apparent reason should raise red flags.
It is usually a sign that there is some sort of disagreement over accounting rules or a conflict with members of the management team.
Another thing to look for is the Auditor’s letter, which is included in an annual report.
The letter will incorporate their findings if they believe that the income, cash flow or balance sheet information was presented fairly, and accurately describes the company’s financial status.
However, if an auditor question if the company has the ability to continue “as a going concern,” or notes some other discrepancy in accounting practices, that should serve as a serious warning sign as well.
6. Insider and Institutional Sales
It could potentially be a bad sign if insiders and large institutional investors are selling a huge amount of shares of a company. Those smart money investors typically dump their shares ahead of a bankruptcy filing or really difficult times before retail investors.
However, it is normal that these smart money players may sell the stock from time to time. Insiders may sell their shares due to any reason, such as diversify their holdings and because of personal liquidity needs.
Essentially, retail investors should pay attention to unusually large or frequent sell-offs.
This is especially so when those transactions occur in or around the time when negative news is released.
7. Disposing Company Assets
It is common that people would sell off their property such as houses and cars to pay off their debts during hard times. The same thing goes for a company that having a tough time in generating income and running out of cash.
Cash is important for a company to operate and meet its debt obligations. The easiest way for a company to raise cash is to sell off its assets.
Therefore, if you see a company selling off its property or business equipment in order to raise cash, it is not a very good sign.
One example is how NOL (now delisted) sold off its building last time – https://sg.news.yahoo.com/nol-building-sold-380m-030629297–sector.html
The Bottom Line
It is important for investors to look out of the red flags before making an investment. Further investigation should be taken when investors came across those companies to understand more about their management.
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