As you gain investing experience and spend more time researching future investments, you gradually become fluent in the language of stock analysis. In this time, you learn what factors might predict a stock’s future success and what ways to determine how a stock might fit into your portfolio’s management strategy. Among other factors, you also learn to understand your risk preferences and calculate your portfolio’s overall rate of return.
However, in this process, you cannot only look for factors that would make a stock a good purchase, but you also learn to notice various “red flags”, or indicators that might give you a good reason not to buy a specific stock. Oftentimes, these red flags indicate financial issues for the company in question. Red flags in the stock analysis may be found in the items that appear in a company’s quarterly financial statements – or may even be factors that are easily discernable from public news sources.
It should be no secret that many of these red flags exist and frequently deter investors from purchasing certain stocks – especially when investors begin to take their own preferences and personal timelines into consideration. For this reason, the discovery of red flags has become a routine component of stock analysis for investors, many of whom have adopted a good rule of thumb of looking back at a company’s financial records for at least three years before proceeding with an investment decision.
However, as you likely already know, all investors have the liberty to be as meticulous with their stock-picking analysis as they want to be – meaning that each investor can mold this style of analysis into his or her own routine in the way that works best for them. To help you determine how to proceed with your own red flag analysis, we have compiled a list of several of the most common red flags that investors typically come across when evaluating a company’s financial statements.
1. Company Profits
Even the best business plans cannot succeed without turning profits. For this red flag, you might ask: how long has it been since the company last earned profits? And, if you truly think that the company’s business model is great and its products are scalable, why might the company still not be turning profits? If you see records from many quarters in a row where a company has not been able to turn profits, this might indicate a fundamental problem with some part of the company’s business.
Compliance issues certainly hurt. For this red flag, you must ask: is the company under investigation for anything? If so, this could be an indication that the company is not abiding by the necessary regulations for operation. Of course, such an indication could predict bad future press and even hefty fines for the company down the road, which might make investors wary.
3. Long-term Debt
Has the company consistently taken on more debt without adding equal or greater value? This red flag could point to a future problem that the company might encounter if it cannot regularly pay off its debts. Obviously, this kind of an issue is not a strong indication of financial health.
4. High Inventories
Finally, if a company’s inventory levels are extremely high, it might be an indication that the company is having trouble selling its products. Clearly, if this trend continues over time, investors may want to look for reasons as to why the company’s products could be selling less than expected.
Of course, these red flags are not “end-all” factors in determining whether or not to buy a stock, but they should certainly play a strong role in an investor’s understanding of a company’s financial health. It goes without saying, but a company’s financial health can ultimately be representative of its stock price. So, the next time you are researching a stock, you may want to consider looking into the company’s financial records for some red flags before putting your money down!