Signs That a Company Is in Trouble
This article talks about some key signs of trouble that you may find within a financial report. Many companies put out glossy financial reports more than 100 pages long with the most graphically pleasing sections providing only the news about the company that its managers want you to read. Don’t be fooled.
Take the time to read the pages in smaller print and the ones without the fancy graphics, because these pages are where you find the most important financial news about the company.
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 that a company can quickly convert to cash, such as marketable securities and certificates of deposits.
Other assets take longer to turn into cash, but they can be more liquid than long-term assets, such as a building or equipment. Take, for instance, accounts receivable. Accounts receivable can often be liquid holdings, provided that the company’s customers are paying their bills on time. If customers are paying their bills late, the company’s accounts receivable are less liquid, meaning that it takes longer for the company to collect that cash.
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
Everyone wants to know how much money a company makes — in other words, its profits. 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, looking at the past five years or more is a good idea.
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.
Any time 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 playing
A day rarely goes by when you don’t see a story about company bigwigs who’ve played with their firm’s revenue results. Although the number of companies being exposed for revenue problems has certainly fallen since the height of scandals set off by the fall of Enron in 2001, a steady stream of reporting about the games companies play with their revenue continues.
Problems can include managing earnings so results look better than they really are and actually creating a fictional story about earnings.
Unfortunately, the only way that a member of the general public can find out about these shenanigans is from the financial press. If the SEC or one of the country’s state attorneys general begins an investigation, you likely won’t know about it until the financial press decides to report on it.
The SEC does post details about its investigations. Usually, by the time that info is posted, the financial press has already done a story.
The initial stages of an investigation usually involve private inquiries between the SEC and the company regarding financial information filed on one of the SEC’s required forms. These initial inquiries aren’t discussed publicly. Only after the SEC decides that a company isn’t cooperating does it start a formal investigation.
When the SEC does start a formal investigation, the company must put out a press release to inform the general public (as well as its investors, creditors, and others interested in the company) that the SEC has some questions about the company’s financial reports.
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.
You can test a company’s debt situation by using debt ratios, which are calculated using numbers from the balance sheet and income statement. You can 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
Some firms can make themselves look financially healthier by either overvaluing their assets or undervaluing their 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. That tactic is just one of the ways Enron and other scandal-ridden companies have tried to hide their problems. If a firm hides its problems well to offset the overvaluing of assets or the undervaluing of liabilities, equity is probably overstated as well.
If you suspect a company of either possibility, it’s a clear sign of trouble ahead. Certainly, you can begin to 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) developed by the Financial Accounting Standards Board (FASB). 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 a potential problem by changing its accounting methods. For example, all firms must account for their inventory by using one of five methods. Changing from one method to another can have a great impact on the bottom line. To find out whether this kind of change has occurred, read the fine print in the financial notes.