If you don't recognize a company's danger signs by reading the financial reports, your investment decisions may not be the best ones. The following are key signs of trouble that you may find within these pages.
Lower liquidity
Liquidity is the ability of a company to quickly convert assets to cash so that it can pay its bills and meet other debt obligations, such as a mortgage payment or a payment due to bond investors. The most liquid asset a company holds is cash in a checking or savings account. Other good liquid sources are holdings such as marketable securities and certificates of deposits.
Another sign of trouble may be inventory. If a company's inventory continues to build, it may have less and less cash on hand as it ties up more money in the products it's trying to sell.
Low cash flow
If you don't have cash, you can't pay your bills. The same is true for companies. You need to know how well a company manages its cash, and you can't do that just by looking at the balance sheet and income statement, because neither of these statements reports what's actually happening with cash.
The only way you can check out a company's cash situation is by using the cash flow statement.
Disappearing profit margins
A company's profit dropping year to year is another clear sign of trouble.
Companies must report their profit results for the current year and the two previous years on their income statements, one of the three key financial statements that are part of the financial reports. When investigating a company's viability, look at the past five years.
Luckily, finding a company's historical profit data isn't hard. In the investor relations section on their website, most companies post financial reports for the current year and two or more previous years. The Securities and Exchange Commission (SEC) also keeps previous years’ reports online at Edgar.
Anytime you notice that a company's profit margins have fallen from year to year, take it as a clear sign that the company is in trouble.
Revenue game paying
Unfortunately, the only way that a member of the general public can find out about fictional earnings is from the financial press. The SEC does post details about its investigations.
The initial stages of an investigation usually involve private inquiries between the SEC and the company. Only after the SEC decides that a company isn't cooperating does it start a formal investigation, at which point the company must put out a press release to inform the general public that the SEC has questions.
Too much debt
Borrowing too much money to continue operations or to finance new activities can be a major red flag that indicates future problems for a company, especially if interest rates start rising. Debt can overburden a company and make it hard for the business to meet its obligations, eventually landing it in bankruptcy.
Compare a company's debt ratios with those of others in the same industry to judge whether the company is in worse shape than its competitors.
Unrealistic values for assets and liabilities
Overvalued assets can make a company appear as if its holdings are worth more than they are. For instance, if customers aren't paying their bills but the accounts receivable line item isn't properly adjusted to show the likely bad debt, accounts receivable will be higher than they should be.
Undervalued liabilities can make a company look as though it owes less than it actually does. An example of this is debts moved off the balance sheet to another subsidiary, to hide the debt.
You should suspect a problem if you see stories in the newspapers about the SEC or state authorities raising questions regarding the company's financial statements.
A change in accounting methods
Accounting rules are clearly set in the generally accepted accounting principles (GAAP). You can find details about the GAAP at the FASB's website. Sometimes a company can file a report that's perfectly acceptable by GAAP standards, but it may hide potential problems by changing its accounting methods. To find out whether this has occurred, read the fine print in the financial notes.
Questionable mergers and acquisitions
Most times, you won't know whether a merger or acquisition will actually be good for a company's bottom line until years later, so be careful.
If you don't already own the stock, stay away until the dust settles. If you do own shares of stock, you'll be able to vote for or against the merger or acquisition if it involves the exchange of stock. You can get to know the issues by reading what the company sends out when it seeks your vote. Follow the stories in the financial press, and read reports from analysts.
The key place to find out about the impact of mergers and acquisitions is in the notes to the financial statements.
Slow inventory turnover
One way to see whether a company is slowing down is to look at its inventory turnover. As a product's life span nears its end, moving that product off the shelf tends to be harder.
When you see a company's inventory turnover slowing down, it may indicate a long-term or short-term problem. Economic conditions, such as a recession may be the cause of a short-term problem. A long-term problem may be a product line that isn't kept up-to-date.
Slow-paying customers
Companies report their sales when the initial transaction occurs. When a customer pays with a credit card issued by a financial institution, the company considers it cash. But credit issued to the customer directly by the company selling the product isn't reported as cash received.
Businesses track noncash sales to customers who buy on credit in an account called accounts receivable. If you see a company's accounts receivable numbers continuing to rise, it may be a sign that the company may face a cash flow problem.