In this article, we’ll use the information described in our analysis of the income statement, balance sheet, and cash flow statement to list out 10 “red flags” to look for. These red flags can indicate that a company may not present an attractive investment based on the three main pillars: growth potential, competitive advantages, and strong financial health. Conversely, a company with few or none of these red flags is probably worth consideration.
The red flags, in no particular order, are:
- A several year trend of declining revenues. While a company can improve profitability by eliminating wasteful spending, cutting unnecessary headcount, improving inventory management, and so forth, long term growth is dependent on sales growth. A company with 3 or more consecutive years of declining revenues is a questionable investment – any cost efficiencies can usually be realized over that period of time. More often, declining revenues is indicative of a declining business – rarely a good investment.
- A several year trend of declining gross, operating, net, and/or free cash flow margins. Declining margins may indicate that a company is becoming bloated, or that management is chasing growth at the expense of profitability. This one has to be taken in context. A declining macro-economic picture or a cyclical company can lower margins without indicating any intrinsic decline in operations. If you can’t reasonably attribute margin weakness to outside factors, beware.
- Excessively rising outstanding share count. Watch out for companies who’s share count consistently rises more than 2-3% per year. This indicates that management is giving away the company and diluting your stake through options or secondary stock offerings. The best case here is to see share count declining 1-2% per year, showing that management is buying back stock and increasing your stake in the enterprise.
- Rising debt-to-equity and/or falling interest coverage ratios. Both of these are an indication that the company is taking on more debt than it’s operations can handle. Although there are few hard targets in investing, take a closer look if debt-to-equity is over 100% or interest coverage ratio is 5 or less. Take an even closer look if this red flag is accompanied by falling sales and/or falling margins. If so, this stock may not be in very good financial health. (Interest coverage is calculated as: net interest payments / operating earnings).
- Rising accounts receivable and/or inventories, as a percentage of sales. The purpose of a business is to generate cash from assets – period. When accounts receivable are rising faster than sales, it indicates that customers are taking longer to give you cash for products. When inventories rise faster than sales, it indicates that your business is producing products faster than they can be sold. In both cases, cash is tied up in places where it cannot generate a return. This red flag can indicate poor supply chain management, poor demand forecasting, and too loose credit terms for customers. As with most of these red flags, look for this phenomenon over a several year period, as short-term issues are sometimes due to uncontrollable market factors (like today).
- Free cash to earnings ratios consistently under 100%. This is closely related to the above red flag. If free cash flow is consistently coming in under reported earnings, some serious investigation is needed. Usually, rising accounts receivable or inventory is the culprit. However, this red flag can also be indicative of accounting tricks such as capitalizing purchases instead of expensing them, which artificially inflates the income statement net profit number. Remember, only the cash flow statement shows you discrete cash values – everything else is subject to accounting “assumptions”.
- Very large “Other” line items 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 given to them is small enough to not be a concern. However, if these line items are significant as a percentage of total business, dig deep to find out what’s included. Are the expenses likely to recur? Is any part of these “other” items shady, such as related party deals or non-business related items? Large “other” items can be a sign of management trying to hide things from investors. We want transparency, not shadiness.
- Lots of non-operating or one-time charges on the income statement. Good companies have very easy to understand financial statements. On the other hand, firms that are trying to play tricks or hide problems often bury charges in the aforementioned “other” categories, or add numerous line items for things like “restructuring”, “asset impairment”, “goodwill impairment”, and so forth. A several year pattern of these “one-time” charges is a concern. Management will tout their improving non-GAAP, or pro-forma, results – but in truth there has been little improvement. These charges are a way of confusing investors and trying to make things look better than they are. Watch the cash flow statement instead.
- Current ratio under 100%, especially for cyclical companies. This is another financial health measure, calculated as (current assets / current liabilities). This measures a company’s liquidity, or their ability to meet their obligations over the next 12 months. A current ratio under 100% is not a huge concern for firms that have a stable business and generate lots of cash (think Proctor and Gamble (PG)). But for very cyclical companies that could see 25% of their revenues disappear in one year, it’s a huge concern. Cyclical + low current ratio = recipe for disaster.
- Poor return on capital when adding in goodwill. This one is specifically geared to Magic Formula investors. Joel Greenblatt’s The Little Book that Beats the Market removes out goodwill for the purposes of calculating return on capital. However, if growth is financed by overpaying for acquisitions, return on capital will look great because the amount of overpayment is not accounted for. MagicDiligence always looks at both measures, with and without goodwill. If the “with goodwill” number is low, the high MFI return on capital is a mirage.