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10 Red Flags in Financial Statement Filings
In this article, we will use the information presented in our analysis of the income statement, balance sheet, and cash flow statement to list 10 “red flags” to look for. These red flags can indicate that a company may not present an attractive investment based on three key pillars: growth potential, competitive advantages, and strong financial health. Conversely, a company with few or none of these red flags is probably worth considering.
Red flags, in no particular order, include:
A trend of several years of declining incomes.
While a company can improve profitability by eliminating unnecessary costs, cutting unnecessary overhead, improving inventory management, etc., long-term growth depends on sales growth. A company with 3 or more years of declining earnings is a questionable investment – any cost savings can usually be realized over that period. Often times, a drop in revenues is a sign of a declining business—rarely a good investment.
A multi-year trend of declining cash, operating, net, and/or free cash margins.
Declining margins may indicate that a company is on fire, or that management is chasing growth at the expense of increased profitability. This should be taken in context. A declining macro-economic picture or a cyclical company can reduce margins without showing any inherent decline in operations. If you can’t reasonably attribute margin weakness to external factors, beware.
The number of outstanding shares is increasing.
Note that companies whose share numbers increase by more than 2-3% each year. This indicates that management is paying the company and reducing your stake through options or secondary stock offerings. The best situation here is to see the share count decrease 1-2% per year, indicating that management is buying back stock and increasing your stake in the company.
An increase in debt-to-equity coverage rates and/or a drop in interest rates.
Both of these are signs that the company is taking on more debt than it can service. Although there are some tough goals in investing, take a closer look if the debt-to-equity ratio is more than 100% or the interest coverage ratio is 5 or less. If this red flag is accompanied by declining sales and/or declining margins, take a closer look. If so, this stock may not be in very good financial health. (The interest statement is calculated as: net interest payments / operating income).
Increase in accounts receivable and/or inventories, as a percentage of sales.
The purpose of a business is to generate cash from capital – period. When accounts receivable are increasing faster than sales, this indicates that customers are paying you for products. When inventories increase faster than sales, it indicates that your business is producing products faster than they are being sold. In both cases, money is tied up in places where it cannot generate returns. This red flag can indicate poor supply chain management, poor demand forecasting, and very weak credit terms for customers. As with most of these red flags, look for this phenomenon over a period of several years, as short-term problems are sometimes due to uncontrollable market factors (like today).
Free cash flow to income ratios consistently under 100%.
This is closely related to the red flag above. If free cash flow consistently falls below reported earnings, some serious research is needed. Usually, an increase in accounts receivable or inventory is the culprit. However, this red flag can also be an indication of accounting tricks such as buying capital instead of spending it, which artificially inflates the net profit figure. Remember, only the cash flow statement shows you discrete cash values - everything else depends on accounting “assumptions”.
“Other” on the income statement or balance sheet.
These include “other expenses” on the income statement, and “other assets”/”other liabilities” on the balance sheet. Most firms have these, but the value they pay is so low that it’s not a concern. However, if these line items are significant as a percentage of the total business, dig deeper to find out what’s included. Could the costs be recurring? Is any part of this similar to “other” items, such as related party transactions or non-business items? Large “other” items can be a sign of management trying to hide things from investors. We want transparency, not shadows.
Many non-operating or one-time expenses on the income statement.
Good companies have easy to understand financial statements. On the other hand, firms that try to play tricks or hide problems often hide charges in the “other” categories above, or for things like “restructuring”, “asset reduction”, “goodwill reduction”. ” what is up. forward The multi-year pattern of these “one-off” charges is concerning. Managers will improve their non-GAAP, or pro-forma, results – but in reality there is little improvement. These fees are a way of confusing investors and trying to make things look better than they are. Watch the cash flow statement instead.
The current ratio is below 100%, especially for cyclical companies.
This is another measure of financial health, calculated as (current assets / current liabilities). This measures a company’s ability, or their ability to meet their obligations over the next 12 months. A current ratio below 100% is not a big concern for companies that have a stable business and generate a lot of cash (think Proctor and Gamble (PG)). But for highly circular companies that can see 25% of their revenues disappear in a year, it’s a big worry. Cyclical rate + current low = recipe for disaster.
Poor return on capital while increasing goodwill.
This one is specially designed for Formula Magic investors. Joel Greenblatt’s The Little Book that Beats the Market excludes goodwill for purposes of calculating return on capital. However, if the growth is financed by paying more on acquisitions, the return on capital will look very good because the amount of the overpayment is not considered. MagicDiligence always looks at both measures, voluntarily and without. If the “voluntary” number is low, the MFI’s high return on capital is a mirage.
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