For those of you without English as a first language, ‘red flags’ are a term used to describe a massive potential problem with the security or viability of an investment, and they often lead to dismissing an investment. Red Flags are an indicator of an underlying problem with the company in question, such as their practices or history.
Whenever you’re looking into a potential company to invest in, due diligence is always recommended. It’s no use investing in a company of which you know nothing about, while it’s also no use taking too long with your research, as the stock prices may have fluctuated by then. A general rule of thumb when looking to invest is to investigate the last 3 years’ records, and the last 3 CFO reports.
Some businesses require a more in depth search than others, with large public companies usually being the most transparent. Companies with a complete financial record, and those with an independent financial audit, are often the best choice for investments. An incomplete financial record is a massive red flag for any company, and those with this should be approached with caution.
One of the easiest red flags for any non-expert to see is the debt-to-equity ratio ; if this ratio comes out at above 100%, this points to a cash flow or spending problem. There are some exceptions to this rule, but in general the ratio is a great indicator of the success of a business. If a company has problems with paying its debt, then it’s likely not a wise investment.
Even with a good debt-to-equity ratio, companies can have major red flags when looked at in detail. One example of this is seen by looking at quarterly revenue compared to their predicted quarterly projections. Obviously, no company gets this projection 100% every time, there’s simply too many variables to consider, but the comparison still shows alot about a company. Those with good-looking financial projections, but lacklustre quarterly analysis, would not be good investments. This red flag shows a deep-rooted problem within a company, weather on the accounting side, or their approach to business. Great projections do not mean a great investment.
Another way of seeing if a company is ‘fooling itself’ is by looking at their accounts recievables, and comparing this with their inventories and services. If the company is sitting on a large stockpile of its services or products, it is easy to see that they have trouble in the sales department. Every company aims to be profitable, by maintaining enough stock to deal with any custom which may occur, while simultaneously avoiding overstocking and wastage, weather through added rent or stock loss. If a company is gaining more of its product over time without any being sold or traded, then this is a huge red flag.
There are many red flags that every investor should be aware of, but by using a trusted and reliable accountant or broker, the risks will be minimized. Due diligence only goes so far, and an expert should be used for advice when possible; they can spot red flags that untrained people simply don’t consider.