| In this article, we'll use the information described in | | | | several year period, as short-term issues are |
| our analysis of the income statement, balance sheet, | | | | sometimes due to uncontrollable market factors (like |
| and cash flow statement to list out 10 "red flags" to | | | | today). |
| look for. These red flags can indicate that a company | | | | 6. Free cash to earnings ratios consistently under |
| may not present an attractive investment based on | | | | 100%. This is closely related to the above red flag. If |
| the three main pillars: growth potential, competitive | | | | free cash flow is consistently coming in under |
| advantages, and strong financial health. Conversely, a | | | | reported earnings, some serious investigation is |
| company with few or none of these red flags is | | | | needed. Usually, rising accounts receivable or |
| probably worth consideration. | | | | inventory is the culprit. However, this red flag can |
| The red flags, in no particular order, are: | | | | also be indicative of accounting tricks such as |
| | | | capitalizing purchases instead of expensing them, |
| 1. A several year trend of declining revenues. While a | | | | which artificially inflates the income statement net |
| company can improve profitability by eliminating | | | | profit number. Remember, only the cash flow |
| wasteful spending, cutting unnecessary headcount, | | | | statement shows you discrete cash values - |
| improving inventory management, and so forth, long | | | | everything else is subject to accounting |
| term growth is dependent on sales growth. A | | | | "assumptions". |
| company with 3 or more consecutive years of | | | | 7. Very large "Other" line items on the income |
| declining revenues is a questionable investment - any | | | | statement or balance sheet. These include "other |
| cost efficiencies can usually be realized over that | | | | expenses" on the income statement, and "other |
| period of time. More often, declining revenues is | | | | assets"/"other liabilities" on the balance sheet. Most |
| indicative of a declining business - rarely a good | | | | firms have these, but the value given to them is |
| investment. | | | | small enough to not be a concern. However, if these |
| 2. A several year trend of declining gross, operating, | | | | line items are significant as a percentage of total |
| net, and/or free cash flow margins. Declining margins | | | | business, dig deep to find out what's included. Are |
| may indicate that a company is becoming bloated, or | | | | the expenses likely to recur? Is any part of these |
| that management is chasing growth at the expense | | | | "other" items shady, such as related party deals or |
| of profitability. This one has to be taken in context. A | | | | non-business related items? Large "other" items can |
| declining macro-economic picture or a cyclical | | | | be a sign of management trying to hide things from |
| company can lower margins without indicating any | | | | investors. We want transparency, not shadiness. |
| intrinsic decline in operations. If you can't reasonably | | | | 8. Lots of non-operating or one-time charges on the |
| attribute margin weakness to outside factors, | | | | income statement. Good companies have very easy |
| beware. | | | | to understand financial statements. On the other |
| 3. Excessively rising outstanding share count. Watch | | | | hand, firms that are trying to play tricks or hide |
| out for companies who's share count consistently | | | | problems often bury charges in the aforementioned |
| rises more than 2-3% per year. This indicates that | | | | "other" categories, or add numerous line items for |
| management is giving away the company and diluting | | | | things like "restructuring", "asset impairment", "goodwill |
| your stake through options or secondary stock | | | | impairment", and so forth. A several year pattern of |
| offerings. The best case here is to see share count | | | | these "one-time" charges is a concern. Management |
| declining 1-2% per year, showing that management is | | | | will tout their improving non-GAAP, or pro-forma, |
| buying back stock and increasing your stake in the | | | | results - but in truth there has been little |
| enterprise. | | | | improvement. These charges are a way of confusing |
| 4. Rising debt-to-equity and/or falling interest | | | | investors and trying to make things look better than |
| coverage ratios. Both of these are an indication that | | | | they are. Watch the cash flow statement instead. |
| the company is taking on more debt than it's | | | | 9. Current ratio under 100%, especially for cyclical |
| operations can handle. Although there are few hard | | | | companies. This is another financial health measure, |
| targets in investing, take a closer look if | | | | calculated as (current assets / current liabilities). This |
| debt-to-equity is over 100% or interest coverage | | | | measures a company's liquidity, or their ability to |
| ratio is 5 or less. Take an even closer look if this red | | | | meet their obligations over the next 12 months. A |
| flag is accompanied by falling sales and/or falling | | | | current ratio under 100% is not a huge concern for |
| margins. If so, this stock may not be in very good | | | | firms that have a stable business and generate lots |
| financial health. (Interest coverage is calculated as: net | | | | of cash (think Proctor and Gamble (PG)). But for very |
| interest payments / operating earnings). | | | | cyclical companies that could see 25% of their |
| 5. Rising accounts receivable and/or inventories, as a | | | | revenues disappear in one year, it's a huge concern. |
| percentage of sales. The purpose of a business is to | | | | Cyclical + low current ratio = recipe for disaster. |
| generate cash from assets - period. When accounts | | | | 10. Poor return on capital when adding in goodwill. This |
| receivable are rising faster than sales, it indicates that | | | | one is specifically geared to Magic Formula investors. |
| customers are taking longer to give you cash for | | | | Joel Greenblatt's The Little Book that Beats the |
| products. When inventories rise faster than sales, it | | | | Market removes out goodwill for the purposes of |
| indicates that your business is producing products | | | | calculating return on capital. However, if growth is |
| faster than they can be sold. In both cases, cash is | | | | financed by overpaying for acquisitions, return on |
| tied up in places where it cannot generate a return. | | | | capital will look great because the amount of |
| This red flag can indicate poor supply chain | | | | overpayment is not accounted for. MagicDiligence |
| management, poor demand forecasting, and too | | | | always looks at both measures, with and without |
| loose credit terms for customers. As with most of | | | | goodwill. If the "with goodwill" number is low, the high |
| these red flags, look for this phenomenon over a | | | | MFI return on capital is a mirage. |