Can I Tell Profit Yoy On Statement Of Cash Flow 10 Red Flags in Financial Statement Filings

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10 Red Flags in Financial Statement Filings

In this article, we’ll use the information described in our analysis of the income statement, balance sheet, and cash flow statement to identify 10 “red flags” to look out for. These red flags can indicate that a company may not represent an attractive investment based on three main pillars: growth potential, competitive advantages and solid financial health. Conversely, a company with few or none of these red flags is likely worth considering.

Red flags, in no particular order, are:

  1. A multi-year trend of declining revenue.

    While a company can improve profitability by eliminating wasteful spending, reducing unnecessary headcount, improving inventory management, and so on, long-term growth depends on sales growth. A company with 3 or more consecutive years of declining revenue is a questionable investment – any cost efficiency can usually be achieved over that time period. More often than not, a decline in revenue is a sign of a failing business—rarely a good investment.

  2. A multi-year trend of declining gross, operating, net and/or free cash flow margins.

    Declining margins may mean the company is becoming bloated or that management is chasing growth at the expense of profitability. This has to be taken in context. A worsening macroeconomic picture or a cyclical business can reduce margins without implying any internal decline in business. If you can’t reasonably attribute margin weakness to external factors, be cautious.

  3. Excessively increasing number of outstanding shares.

    Watch out for companies whose stock numbers are consistently increasing by more than 2-3% per year. This means that management divests the company and reduces your stake through options or secondary stock offerings. The best example is to see the number of shares declining 1-2% per year, indicating that management is buying back shares and increasing your stake in the company.

  4. A rising debt-to-equity ratio and/or a falling interest coverage ratio.

    Both are signs that a company is taking on more debt than its operations can handle. While there are few hard targets when it comes to investing, take a closer look if your debt-to-equity ratio is greater than 100% or your interest coverage ratio is 5 or less. Pay even more attention if this red flag is accompanied by declining sales and/or declining margins. If so, this stock may not be in very good financial shape. (Interest coverage is calculated as: net interest payments / operating profit).

  5. Increasing accounts receivable and/or inventory as a percentage of sales.

    The purpose of the business is to generate cash from assets – period. When receivables grow faster than sales, it means customers are taking longer to give you money for products. When inventory grows faster than sales, it means your business is producing products faster than they can be sold. In both cases, money is tied up in places where it cannot generate returns. This red flag can indicate poor supply chain management, poor demand forecasting and too loose customer credit terms. As with most of these red flags, look for this phenomenon over a period of several years, as short-term problems are sometimes the result of uncontrollable market factors (like today).

  6. Free cash to profit ratio consistently below 100%.

    This is closely related to the red flag above. If free cash flow consistently comes in below reported earnings, a serious investigation is warranted. Rising receivables or inventory are usually the culprit. However, this red flag can also indicate accounting tricks, such as capitalizing purchases instead of expenses, 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”.

  7. Very large “Other” items in the income statement or balance sheet.

    These include “other expenses” in the income statement and “other assets”/”other liabilities” in the balance sheet. Most companies have them, but their value is small enough not to cause concern. But if those line items are significant as a percentage of the overall business, dig deeper to find out what’s included. Is the cost likely to recur? Are any of these “other” items suspicious, such as related party transactions or non-business items? Large “other” items can be a sign that management is trying to hide things from investors. We want transparency, not shadow.

  8. Lots of non-operating or non-recurring expenses on the income statement.

    Good companies have very easy to understand financial statements. On the other hand, companies trying to play up or cover up problems often bury expenses in the aforementioned “other” categories or add numerous line items for things like “restructuring,” “asset impairment,” “goodwill impairment,” etc. forward. The multi-year pattern of these “one-time” costs is alarming. Management will tout its improvements in non-GAAP or pro-forma results – but in reality, there has been little improvement. These charges are a way of confusing investors and trying to make things look better than they are. Instead, look at the cash flow statement.

  9. Current ratio below 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. Currently, a ratio below 100% is not a big concern for companies that have stable operations and generate a lot of cash (think Proctor and Gamble ( PG )). But for highly cyclical businesses where 25% of their revenue can disappear in a year, this is a major concern. Cyclic + low current ratio = recipe for disaster.

  10. Poor return on capital when adding goodwill.

    This one is specifically for Magic Formula investors. Joel Greenblatt’s The Little Book that Beats the Market removes goodwill for purposes of calculating return on capital. However, if the growth is financed by the overpayment for acquisitions, the return on capital will look great because the amount of the overpayment is not taken into account. MagicDiligence always considers both measures, with and without goodwill. If the “goodwill” figure is low, the MFI’s high return on capital is just an illusion.

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