16 Red Flags to Watch for in a Company’s Financial Statements
Use our handy financial health checklist to spot potential problems in a stock before they cause you to incur a large loss.
Analyzing financial statements can help you avoid stocks with significant underlying risks. The numbers within the statements can reveal deteriorating trends, excessive debt, customer problems and other issues that may lead to a drop in the stock’s price.
The potential problems identified may be ones either not mentioned or downplayed by corporate executives. Whereas a CEO will try to position their company in the best possible light, the numbers reveal trends as they are—good or bad. Warning signs often show up in the financial statements before they make headlines.
In this installment of our financial statement analysis series, we walk through 16 red flags that may signal business or financial trouble. Recognizing these indicators may help you spot potential problems before your portfolio is harmed by them.
Cash Flow Red Flags
Cash flow refers to how much cash a company has brought in and how much it has paid out. Unlike earnings, which are an accounting figure, cash is required for a company to operate, grow, pay dividends and repurchase stocks.
The cash flow statement is a good place to look for potential financial red flags because it is harder for management to manipulate than the income statement. Three indicators can reveal if a company is incurring challenges in converting earnings into cash.
1. Operating cash flow is negative for consecutive quarters
Cash flow from operating activities tells you how much cash is realized or spent by normal day-to-day business operations. It should be positive over most periods.
Operating cash flow can be negative for a particular quarter due to the timing of transactions. A common example is a large purchase of inventory ahead of fulfilling a customer’s order. CFOs often disclose such transactions during the quarterly earnings conference call.
Seasonality can also play a role. Holiday shopping patterns can cause retailers to have negative operating cash flow during their third quarter and large positive cash flow during their fourth quarter.
When operating cash flow remains negative for more than one reporting period, it often indicates that the firm is spending more than it is bringing in from business activities. Such a situation is not sustainable. A company will need to reduce the size of its operations, secure more debt and/or conduct a secondary offering of shares to raise more capital to stay afloat.
2. Net income exceeds operating cash flow
When net income consistently outpaces operating cash flow, it raises questions about the persistency of earnings. This mismatch is typically due to an overreliance on accrual accounting.
Accrual accounting recognizes transactions when their economic benefits become probable. Cash accounting, in contrast, recognizes transactions when cash exchanges hands. Accrual accounting makes it easier to project future earnings. Problems arise with accrual accounting when future revenue that is expected to offset previous expenditures is not realized.
While some variance between earnings and operating cash flow is not a cause for concern, sustained higher net income relative to cash flow from operations can indicate that the company is boosting earnings with accounting entries rather than real economic activity. This can lead to future write-downs.
Analyze the cash flow statement and footnotes to understand the source of the discrepancy. In some cases, companies may use aggressive assumptions around revenue recognition or understate reserves for bad debts to prop up net income.
3. Free cash flow is consistently negative or declining
Free cash flow is cash available to spend on activities not directly related to the company’s ongoing operations. It is calculated by subtracting capital expenditures (capex) and dividends paid from cash flow from operating activities.
Negative or declining free cash flow is a signal to investigate further. Spending on a new facility to expand operations or pay down debt can temporarily cause free cash flow to be negative. Ongoing capex—listed in the cash from investing activities section of the cash flow statement—that are not accompanied by growth trends on the income statement are problematic. They imply that a company is overspending.
Liquidity Red Flags
Liquidity refers to a company’s ability to meet its short-term obligations. Weak liquidity often precedes more serious financial issues, particularly during downturns or when credit conditions tighten.
Analyzing a company’s liquidity can also reveal problems with a company’s customers. This is a warning sign about problems within the business and/or its industry.
4. Current liabilities exceed current assets
A current ratio below 1.0 indicates that a company cannot meet its short-term obligations with its short-term assets. Timing or seasonal issues can cause the current ratio to be temporarily depressed over certain quarters. An unexpected or a consistent trend of current ratios below 1.0 implies a company may be relying heavily on short-term borrowing or delayed payments to suppliers to keep operations running. (See Table 1 for how to calculate the ratios discussed in this article.)
Table 1. Financial Indicators of Potential Problems
Weakness in one or more of these indicators can raise a red flag about a company’s financial strength and/or its business trends. Many of these indicators can be found or determined by looking at the Ratios and Financials tabs of the Stock Evaluator page at AAII.com. To access the page, type a company’s name or ticker symbol into the search bar at the top of any page at AAII.com.
Download a fillable Financial Health Checklist PDF to identify any red flags for stocks you own or are interested in.
5. Quick ratio below 1.0
The quick ratio, or acid-test ratio, is a stricter measure of liquidity than the current ratio. It excludes inventory and prepaid expenses from current assets since neither can quickly be converted into cash at stated values. Inventory can be devalued from its stated book value because of obsolescence or because demand for it is low.
A quick ratio below 1.0 means the company may not be able to pay off its current liabilities without securing new financing or selling inventory at a loss. Persistent low ratios suggest that the company is operating without a sufficient liquidity buffer.
6. Declining inventory and receivables turnover ratios
The inventory turnover ratio reveals whether inventory is being converted into sales or is languishing in the warehouse or on store shelves. A decline in this ratio indicates weaker demand by customers, a loss of market share to competitors and/or obsolescence.
The receivables turnover ratio measures how quickly customers pay their invoices. Declines in this ratio suggest that the company’s customers are taking longer to pay. This could be due to a shift in the customer base. Slowing (lower) receivables turnover ratios may also signal that the company has loosened its credit policies, the company’s customers are seeing weakening demand for their products or the company’s customers are struggling financially. A decline in this ratio is particularly worrisome for companies whose revenues primarily come from a small number of key customers.
Companies with seasonal or cyclical sales trends may see fluctuations in both turnover ratios, but persistent declines are often symptomatic of underlying problems.
7. Rising accounts payable turnover ratios
Accounts payable, found in the current liabilities section of the balance sheet, are the amounts a company owes its vendors and other businesses it uses. Quarterly fluctuations in the accounts payable turnover ratio can occur, but an ongoing or significant decline in the ratio is cause for concern. It suggests that a company is delaying payments to suppliers to conserve cash.
A pattern of slowing accounts payable turnover ratios alongside weak cash flow and other liquidity issues is a big red flag.
Debt and Solvency Red Flags
The inability to service debt can trigger serious problems. Dividends and buybacks may be suspended, growth initiatives may be delayed or canceled, and, in extreme cases, the company may be forced into bankruptcy.
8. Interest coverage ratio near or below 1.0
The interest coverage ratio measures a company’s ability to meet its debt obligations. Ratios near or below 1.0 occur when a company is either barely covering its interest payments with earnings or not covering them at all. (If a loss is reported by a company with interest expense, the ratio cannot be calculated.)
Debt covenants may require the interest coverage ratio to be above a certain level. Even the risk of violating those covenants can force a company to halt expansion plans and/or cut its dividend. Failure to service the debt puts a company into default. Companies may seek to raise additional financing to meet their obligations—a warning sign of a debt spiral.
9. Rising debt-to-equity ratio
Companies taking on more debt will see their debt-to-equity ratio rise. This can be acceptable if the company is financing reinvestment or growth through borrowing rather than through cash or equity. It becomes problematic when the ratio is rising but revenue and earnings growth does not follow.
A debt-to-equity ratio that is significantly higher than a company’s peers is a potential red flag. Comparing this ratio over time can help investors spot creeping leverage, which may not be immediately obvious from the absolute dollar figures alone.
10. Altman Z-Score below 1.8
The Altman Z-Score uses five indicators—relative working capital, retained earnings, earnings before interest and taxes (EBIT), equity, and sales—to assess the probability of a company going bankrupt or incurring significant financial distress. Scores below 1.8 signal a high risk of going bankrupt or at least incurring financial distress within the next two years.
Profitability and Competitive Performance
Declining profitability is a financial red flag because it generally leads to less cash available to be reinvested in the company or to pay down debt. A decline in profitability is also often the first problem to start dragging a stock’s price down.
11. Revenue and profit trends are declining
Revenue declines can be attributable to cyclical factors (or seasonal factors when viewed on a sequential quarterly basis). They can also reflect problems with the company or its industry group, or a combination of cyclical, company and industry problems.
Regardless of the cause, a financial red flag is raised about the company facing demand issues—especially when declining revenues are paired with shrinking profits. Investors should be particularly concerned when the trends indicate that the downturn is not temporary.
12. Profit margins are narrowing
Narrowing gross margins occur when a company realizes a smaller gross profit on every good sold or service provided. The decline in gross profitability can be caused by competitive pressures, higher costs, weakening demand, increased inefficiencies or a combination of these factors. Declining revenues and narrowing gross margins are particularly worrisome because they point to an inability to sell goods at favorable prices.
Operating margins not only consider the cost of revenues but also overhead costs, depreciation and amortization costs. Operating margins that are shrinking faster than gross margins occur when a company is having problems managing its operating costs.
Taken together, shrinking profit margins often indicate challenges in managing both input costs and internal expenses (Figure 1).
13. Revenue and profit trends are out of sync with industry peers
Comparing a company’s revenue and profit trends to its peers will tell you whether the profitability issues are at least somewhat caused by industry or sector headwinds. Companies that are stagnating while their competitors are growing revenues and profits should be approached with caution. This divergence is especially telling when it occurs during periods of broader industry growth.
Additional Financial Red Flags
In addition to the aforementioned ratios and trends, there are a few other financial red flags to watch out for.
14. Assets growing faster than revenues
Continued stronger growth in assets relative to revenues can tip you off to problems. Disproportionate growth in accounts receivable and inventory signals customer and demand problems, respectively. Disproportionate growth in fixed assets or intangibles suggests the company’s expansion plans have been too aggressive.
15. Dividend payout ratio approaching or above 100%
High dividend payout ratios are not sustainable. Particularly worrisome is a high dividend payout ratio with low profitability ratios and/or low-to-negative free cash flow. Unless earnings rebound, the company will be forced to cut its dividend. (Regulated utilities are able to maintain high dividend payout ratios because of their rate agreements with utility regulators.)
16. Piotroski F-Score of 3 or less
The Piotroski F-Score evaluates a company’s financial health based on nine accounting-based criteria, including profitability, leverage and operational efficiency. It works well for doing a primary assessment of whether a company is fundamentally weak (scores of 0 to 3) or fundamentally strong (scores of 7 to 9). Additional analysis should still be conducted, especially if the score is low.
Financial Red Flags Should Not Be Ignored
It can be tempting to downplay a financial red flag, but investors do so at their own peril. An important factor is determining whether the concerning numbers and ratios are attributable to timing and cyclical trends or to a company-specific problem. When uncertain, it is prudent to assume the latter.
Look beyond the earnings releases and financial statements for more information. Earnings conference call transcripts and U.S. Securities and Exchange Commission (SEC) filings, particularly Forms 10-Q and 10-K, provide useful context. Watch for cautionary signs such as frequent restatements of earnings, management turnover (particularly CFO changes) and auditor “going concern” warnings.
Ultimately, the goal of financial red flag analysis is to spot potential problems before they cause you to incur a large loss (or a bigger loss than you’ve already realized).