Low cash flow
A company’s cash flow statements are one of the first places to look for signs of trouble. Negative cash flow occurs when cash payments exceed cash income. Low cash flow occurs when cash income barely covers cash payments. While it is true that even profitable companies can experience low cash flow situations at one time or another due to a variety of factors, consistently low or negative cash flow over a sustained period is often a sign that cash in the bank is running low, and the company is headed for trouble.
Disappearing profit margins
Net profit margin – a company’s net profit divided by its sales – is usually a good measure of a company’s ability to effectively manage its most important costs. In some ways, a company’s net profit margin is more important than the dollar value of its profits because it is a better indicator of a company’s future profitability as it grows. When these profit margins decline from one year to the next, it is a clear sign of trouble. Historical profit reports are available online through the Securities and Exchange Commission. It is best to look at the last five years of data in order to get an accurate sense of a company’s viability.
Too much debt
Debt can quickly overburden a company and prevent it from meeting its financial obligations. Companies that have borrowed heavily in order to finance new activities or that simply continue operations may find themselves in serious difficulty, particularly if interest rates go up. To get a sense of whether a company’s debt load is comparable to others in the industry, it can be helpful to compare its debt ratios with those of its competitors.
Slow inventory turnover
The rate of inventory turnover is a useful indication of whether a company may be slowing down. However, it’s important to distinguish between long- and short-term causes of slow turnover. General economic conditions could be a short-term cause, but slow inventory turnover over a prolonged period could be a sign of a longer-term problem, such as a product line that is not kept current.
A change in accounting methods
Accounting rules are clearly set by a collection of principles known as the “generally accepted accounting principles” (GAAP), which are available online through the Financial Accounting Standards Board. Companies experiencing difficulty sometimes attempt to hide their problems by switching their accounting methods while still abiding by GAAP standards. The fine print in the financial notes will indicate whether a change of this kind has been made.
A change in auditors
Recent academic studies have shown that auditor resignations increase as a company’s financial health deteriorates, so a change in auditors should not be taken lightly. Auditor replacement can indicate a number of serious problems, including disagreement over the reliability of a company’s accounting.
Operational moves that appear to have little purpose other than to give a company a quick infusion of cash could be a sign that a company’s creditors, such as its suppliers or lenders, want to collect on debt that the company is not otherwise in a position to pay. Examples of “cash grabs” include a sudden slashing of prices in order to quickly increase sales volume or the abrupt sale of core business assets.
Relaunching and rebranding
If a company is carrying out a rebranding exercise or relaunch, you should question whether it’s a move that complements the existing business or creates a potential new income stream, or if it’s simply an attempt to lift a flagging performance. A process that does little more than repackage the existing business without significant indications that any flaws are being addressed is usually a cause for concern.
A company facing insolvency will usually make an effort to cut costs wherever possible, and the quality of the products or services is often one of the first things to be sacrificed. Slower delivery times, shoddy workmanship, and a failure to return calls are reliable signs of distress.
Sudden changes at the management level
Resignations, new hires, or changes in responsibility at the management level could be business as usual, but they bear investigating to determine if more serious problems are at the root of these changes. For example, companies in financial difficulty may bring in new management team members to assist in reviewing and changing a company’s business practices. Key resignations may indicate impending bad news. Moreover, greater involvement from senior management in a company’s day-to-day finances could signal tighter cash flow and decreasing revenue.