In this article, we’ll use the information described in our analysis of the income statement, balance sheet, and cash flow statement to list 10 “red flags” to look for. These red flags may indicate that a company may not present an attractive investment based on the three main pillars: growth potential, competitive advantages, and strong financial health. Rather, a company with few or none of these red flags is probably worth considering.
The red flags, in no particular order, are:
- A multi-year trend of declining revenues. While a company can improve profitability by eliminating unnecessary expenses, reducing unnecessary staff, improving inventory management, etc., long-term growth depends on sales growth. A company with 3 or more consecutive years of declining revenue is a questionable investment – any cost efficiencies can usually be achieved during that time period. More often than not, declining revenue is indicative of a declining business, rarely a good investment.
- A multi-year trend of declining gross, operating, net and/or free cash flow margins. Declining margins can indicate that a company is bloating or that management is chasing growth at the expense of profitability. This has to be taken in context. A declining macroeconomic outlook or a cyclical company can reduce margins without indicating an intrinsic decline in operations. If you can’t reasonably attribute margin weakness to external factors, be careful.
- Excessively growing outstanding share count. Beware of companies whose share count is steadily increasing by more than 2-3% per year. This indicates that management is giving away the company and diluting its stake through options or secondary stock offerings. The best case here is to see the share count declining 1-2% per year, which shows that management is buying back shares and increasing their stake in the company.
- Increased and/or decreased interest coverage ratios. Both are an indication that the business is taking on more debt than its operations can handle. Although there are few hard goals in investing, take a closer look at whether the debt-to-equity ratio is greater than 100% or the 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 profit).
- Increase in 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 increase faster than sales, it indicates that customers are taking longer to give you cash for products. When inventories increase faster than sales, it indicates that your company is producing products faster than they can be sold. In both cases, the cash is tied up in places where it cannot generate returns. This red flag can indicate poor supply chain management, poor demand forecasting, and overly easy 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 (such as today).
- Free cash to earnings ratios consistently below 100%. This is closely related to the red flag above. If free cash flow consistently falls short of reported earnings, serious investigation is in order. Usually, increased accounts receivable or inventory is the culprit. However, this red flag can also be indicative of accounting tricks, such as capitalizing purchases instead of spending them, which artificially inflates the net income number on the income statement. 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 companies have them, but the value placed on them is small enough not to be a concern. However, if these line items are significant as a percentage of total business, drill down to find out what is included. Are the expenses likely to recur? Are any of these “other” elements shady, such as related party agreements or non-business related items? The “other” big items can be a sign that management is trying to hide things from investors. We want transparency, not shadows.
- Many non-operating or one-time charges on the income statement. Good companies have financial statements that are very easy to understand. On the other hand, companies that are trying to play tricks or hide problems often bury charges in the “other” categories mentioned above, or add numerous line items for things like “restructuring,” “asset impairment,” “fund impairment.” trade”, etc. go ahead. A multi-year pattern of these “one-off” charges is cause for concern. Management will improve all of its non-GAAP, or pro-forma, results, but there has actually been little improvement. These fees are a way to confuse investors and try to make things look better than they are. Look at the statement of cash flows instead.
- Current ratio less than 100%, especially for cyclical companies. This is another measure of financial health, calculated as (current assets / current liabilities). This measures a company’s liquidity, or its ability to meet its obligations over the next 12 months. A current ratio below 100% is not much of a concern for companies that have a stable business and generate a lot of cash (think Proctor and Gamble (PG)). But for highly cyclical companies that could see 25% of their revenue disappear in a year, it’s a big concern. Cyclic + low current rate = recipe for disaster.
- Poor return on capital when adding goodwill. This one is specifically aimed at Magic Formula investors. The Little Book that Beats the Market by Joel Greenblatt eliminates goodwill for the purpose of calculating return on capital. However, if growth is financed by overpaying for acquisitions, the return on equity will appear excellent because the amount of the overpayment is not taken into account. MagicDiligence always looks at both measures, with and without good will. If the “good will” number is low, the MFI’s high return on capital is a mirage.