As a financial adviser, you are responsible for paying close attention to your clients’ investments and watching for investments that may fail. Learn how to determine whether a company is on the verge of bankruptcy or facing severe financial difficulties. It is also easy to learn how to analyze benefits.
Warning signs for troubled companies
Cash or loss reduction
Companies that lose money quarter after quarter will quickly consume cash. Be sure to check the company’s balance sheet and its cash flow statement to determine how cash is used. In addition, compare the current cash flow and cash holdings with the same period of the previous year to determine whether there is a trend.
If the company consumes cash due to increased investment activities, it may mean that the company is investing in the future. However, if in the cash flow statement, the company consumes cash in operating activities, if the cash generated from operating activities is negative, it may cause concern. Also, note the substantial increase in cash because the company sold long-term assets, which are reflected as cash inflows from investment activities. If they do, they will sell an income-generating asset for short-term cash injection, but future cash flow may weaken.
The company should also have retained earnings, which is the money left over after making profits over a period of time. In fact, renewable energy is a company’s savings account, which accumulates profits over time and is used to reinvest back in the company, issue dividends, or buy back stocks. If renewable energy does not increase or does not exist, in the absence of dividends and buybacks, the company will either be unprofitable or barely make ends meet.
Questionable interest payment
The company’s income statement will show how much it paid to repay debt. Can the company continue to lose money and still have enough funds to pay interest? Does the current revenue growth generate enough revenue to pay off the company’s debt?
There are some indicators and ratios that can measure the company’s ability to repay debt.
For example, the interest coverage ratio indicates the extent to which the company’s income can cover its interest expenses. Analysts usually look for ratios greater than 1.5 times.
The current ratio (or cash ratio) is another calculation method that helps determine the company’s ability to pay short-term debt. It is calculated by dividing current assets by current liabilities. A ratio higher than 1 indicates that the company is likely to pay off its debts, while a ratio lower than 1 indicates that the company will not be able to pay off its debts. The acid test ratio can also be used, except that it excludes inventory and prepayments from current assets.
All the books of listed companies must be audited by an external accounting firm. Although it is not uncommon for companies to change companies from time to time, the sudden dismissal of auditors or accounting firms for no reason should trigger red flags. This usually indicates a disagreement on how to book revenue or a conflict with management team members. Neither is a good sign.
In addition, please review the auditor’s report included in the company’s annual report (10-K). The auditor must provide a report summarizing whether the information is presented fairly and accurately describing the company’s financial situation, at least to the extent they know it. However, if the auditor questions the company’s ability to continue to “go a going concern” or notice some other differences in accounting practices, especially how it records revenue, this should also be a serious warning sign.
Companies that reduce or cancel dividend payments to shareholders are not necessarily on the verge of bankruptcy. However, when companies go through tough times, dividends are usually the first item to go. Unless absolutely necessary, management is unlikely to cut dividends, because any reduction may cause the company’s stock price to fall sharply. Therefore, regard any dividend cut or cancellation as a sign that a difficult period is approaching.
When determining whether a dividend cut heralds a dark period for the company, it is important to consider other supporting evidence. That is, pay attention to declining or variable profitability, dividend yields compared to other companies in the industry, and negative free cash flow.Wise investors are also prudent; make sure your dividends are risk-free.
Top management defected
Usually, when a company’s situation deteriorates severely, senior members of the management team will leave to work for another company. At the same time, existing employees with lower qualifications will replace senior managers. If the defection of management is stable, this is rarely good news.
Big insider sales
Smart money investors, the institutional and executive holders of stocks, usually dump their stocks before filing for bankruptcy or a truly difficult period. Watch out for insider trading.
However, in the normal course of business, some insiders may sell the stock from time to time. In essence, you should pay attention to unusually large or frequent transactions, especially those that occur at or around the time of negative news.
Sell flagship products
If you are going through some difficult times, you may use your savings. When you experience this, you might consider selling some of your assets to raise funds. But unless absolutely necessary, you will not sell your personal souvenirs. Well, the same logic applies to a company. Therefore, if you see a company selling major departments or product lines to raise cash, please pay attention!
In difficult times, companies will seek to drastically cut their health benefits, pension plans or other benefits. Deep and sudden cuts, especially when they occur at the same time as any of the other problems mentioned above, indicate that trouble may be at hand.
It is not uncommon for companies to encounter bumps on the road and have to tighten their belts. However, if a company tightens this belt excessively, or if there is more than one of the above, please be careful. Pay attention to whether these items appear in the press release or annual prospectus.