It is a proven fact that equity investment has the potential to provide the highest returns in the long term. Therefore, investment in stocks is one of the top ways to increase one’s wealth and build a substantial corpus in the long run. But this largely depends on the choice of stocks to invest in. Any adverse choice and the whole portfolio goes for a toss. So how do you choose good stocks to invest in and more importantly, which stocks to avoid? Given below are a few red flags in a company to watch out for while assessing a company.
Read More: 4 financial ratios for analyzing a company
Analyzing financial statements
The first step of investment is analyzing the company and its sensitivity to market fluctuations. The analysis of the company’s financial statements is the true essence of the fundamental analysis which is crucial for shaping any portfolio. The basis of fundamental analysis is the reviewing of the key ratios of the company, the products or services offered by them and their demand in the market, the stage they are in as per the product life cycle, the management of the company, its competitors, etc. This is a thorough analysis of a company and thereby its stocks to determine if its a safer as well as profitable bet in the short-term or long-term investment horizon.
Red flags in any company
While analyzing the company, investors can come across certain instances or reports that can be considered red flags and may deem the stocks of such a company to be an unfavorable investment opportunity. Some of such red flags that should be considered seriously by the investors are discussed below.
- Window-dressed financial statements
Many organizations have resorted to window-dressing their financial statements while presenting them to the stakeholders. The sole purpose of the same is to project a better picture of the financial health of the organization than it actually is. Investors have to therefore analyze the company’s key ratios and thoroughly review the past financial statements looking for any significant changes in reporting of assets or liabilities, or significant changes in the promoter shareholdings, etc.
- Dumping of shareholdings by promoters
In some cases, if the company is facing a seriously bad time some of the promoters of such a company are usually the first to jump ship. Therefore, any major dumping of stakes by the promoters, especially the key promoters of a company without any concrete plans of using their equity for business expansion, is usually a red flag that all is not well in the organization. A deeper analysis of the financial statements is warranted in such cases before any investment ins such companies.
- Unusual accounting practices
The accounting practices to be followed by an organization are laid out as per the Indian Accounting Standards, Companies Act, 2013, IFRS (International Financial Reporting Standards), and other relevant statutes. Any significant and unexplained deviation from the standard accounting policies that are instrumental in inflating the financial statements is another red flag that the company is not presenting a true and fair view of the financial records to all stakeholders.
- Above-average debt-equity ratio and debt servicing coverage ratio
Debt-equity ratio analysis is part of the fundamental analysis of a company. There is no definitive or standard debt-equity ratio across the industries and it varies depending on the nature of the industry that the company belongs to. However, a continually increasing debt-equity ratio backed by a lower debt-servicing coverage ratio is a big red flag regarding the ability of the company in meeting its mandatory financial obligations.
- Unfavourable audit report or resignation by auditors
The auditors of the company have the responsibility towards the shareholders to report if the financial statements represent the true and fair view of the company in their audit reports. In doing so, they are required to review all the aspects of the business and to report on any discrepancy that is detrimental to the interest of the shareholders.
There have been many occasions when the auditors have issued a negative or a qualified audit report. This is a serious red flag that should not be missed. On several occasions, if it is not possible for the auditors to carry out their engagement in a true and fair manner, they have also resigned from the same. While there may or may not be a qualified or an adverse report on record in such cases, the resignation itself is another red flag that the matters of the company need a serious review.
- Cash negative business
Having enough liquidity is a very crucial requirement to smoothly run the operations of an organization. When a company is cash-strapped, it may not be able to carry out its daily operations with ease and may need to borrow funds to meet its liquidity issues. A constant need for short-term borrowings due to the business being cash-negative is also considered to be a red flag for the stakeholders of such a company.
- Increase in unexplained expenses
There is a line item in the balance sheet ‘Miscellaneous Expenses’ that accounts for out-of-ordinary other expenses of the company that may not fit in any specific ledger. These expenses are written off in the books of accounts but a significant increase in these expenses without any concrete explanation should be treated as a red flag while analyzing a company.
- Non-operating income
Any income for a business is good news. Such income is classified as operating income (income from routine operations of the business) and non-operating income (income from non-core operations of the business). When there is a significant and consistent increase in the non-operating income, especially if such an increase is the sole reason that the profit and loss account is not negative, such incidents should be treated as a red flag too. This can imply that the business is no longer able to generate profits from its core business and has to rely on non-operating income to keep the business afloat. Survival of such a business will be difficult in the long run.
- Increase in inventory and debtors
An increase in inventory and debtors is a sign of a healthy business, provided it is translated into increasing gross margins and net margins for the company. However, in the absence of such an increased bottom line, an increase in the inventory and debtors implies that the stock is either being piled up or there is a lack of proper inventory management, or the production is delayed as there is no space to fit finished goods. Any of such cases is bad news for the company. An increase in debtors, on the other hand, should be backed by increased sales. If not so, increased debtors imply that the credit period needs alterations and stricter follow-up to ensure that such receivables do not turn into bad debts.
Red flags in any company reflect potential wrongdoings or errors in the management of the company. Such red flags need a thorough review and corrective measures to optimize the use of available resources and bring the company back on the right track of growth and profitability. However, if such red flags are consistent and investors and other stakeholders do not see serious redemption on part of the company, investment in such companies should be with caution.
Some of the other red flags that need consideration as well are an irregular cash flow into the organization, lack of management efforts for the profitability of the company, transfer of reserves to other companies, cases of fraud or mismanagement on the Board of Directors or the promoters of the company, lack of representation of minority shareholders, etc.
A company may have many red flags but when no efforts are done by the management to rectify them and bring the company back on the path of transparency, growth, and profitability, investment in such companies then becomes a risky proposition.
Corporate red flags are the indicators or signs that reflect potential wrongdoings and mismanagement in the affairs of a company that is detrimental to the interest of their stakeholders like creditors, lenders, shareholders, and potential investors.
The key components to review in analyzing a company are its financial statements and the key ratios that support the profitability and survival of the company in the long term.