Question

1. Identify possible red flags

Answer 1

Answer : Following are eight red flags that can indicate trouble for a business.

• Rising debt-to-equity ratio: This indicates that the company is absorbing more debt than it can handle. A red flag should be raised if the debt-to-equity ratio is over 100%. You can also take a look at the falling interest coverage ratio, which is calculated by dividing net interest payments by operating earnings. If the ratio is less than five, there is cause for concern.
• Several years of revenue trending down: If a company has three or more years of declining revenues, it is probably not a good investment. While cost-cutting measures—such as wasteful spending and reduction in headcount—can help to offset a revenue downturn, it probably won’t if the company has not rebounded in three years.
• Large “other” expenses on the balance sheet: Many organizations have “other expenses” that are inconsistent or too small to really quantify, which is normal across income statements and balance sheets. If these “other” line items have high values, then you should find out what they are specifically, if you can. You’ll also want to know if these expenses are likely to recur.
• Unsteady cash flow: Cash flow is a good sign of a healthy organization but it should be a flow, back and forth, up and down. A stockpile of cash can indicate that accounts are being settled, but there isn’t much new work coming in. Conversely, a shortage of cash could be indicative of under-billing for work by the company.
• Rising accounts receivable or inventory in relation to sales: Money that is tied up inaccounts receivable or has already been used to produce inventory is money that cannot generate a return. While it’s important to have enough inventory to fulfill orders, a company doesn’t want to have a significant portion of its revenue sitting unsold in a warehouse.
• Rising outstanding share count: The more shares that are available for purchase in the stock market, the more diluted shareholders’ stake in the company becomes. If a company’s share count is rising by two or three percent per year, this indicates they are selling more shares and diluting the organization’s value.
• Consistently higher liabilities than assets: Some organizations experience a steady stream of assets and liabilities as their business does not hinge on seasonal shifts or is less affected by market pressure. For companies that are more cyclical (i.e. construction companies during the winter months), however, it’s possible that its liabilities will outweigh its assets. Technically, this should be something the company can plan around, thereby decreasing the discrepancy. If a company is consistently assuming more liability without a proportionate increase in assets, however, it could be a sign it is over-leveraged.
• Decreasing gross profit margin: As this measures a company’s ratio of profits earned to costs over a set period of time, a declining profit margin is cause for alarm. The profit margin must account not only for the costs to produce the product or service, but the additional money needed to cover operating expenses, such as costs of debt.