Identifying Red Flags

 

Few people seem to spot the early signs of a company in distress. Remember WorldCom and Enron? Not long ago, these companies were worth hundreds of billions of dollars. 

Today, they no longer exist. Their collapses came as a surprise to most of the world, including their investors. Even large shareholders, many of them with an inside track, were caught off guard.

This does not mean it's impossible to see a corporate train wreck before it happens. Sure, it involves some work, but by digging into a company's activities and financial statements, even the average investor can identify potential problems. Here are some general guidelines for spotting companies that may be headed for trouble.

Cashflows
Keeping a close eye on cashflow which is a company's life line, can guard against holding a worthless share certificate. When a company's cash payments exceed its cash receipts, the company's cashflow is negative. If this occurs over a sustained period, it is a sign that cash in the bank may become dangerously low. Without fresh injections of capital from shareholders or financiers, a company in this situation can quickly find itself insolvent.

Bear in mind that even profitable companies can have negative cash flows and find themselves in trouble. This can happen, for example, when a rapidly growing business with strong sales makes large investments in stock, staff and manufacturing plants. At best, there will be a delay between when the company forks out cash for these business costs and when it collects cash from resulting sales. But this delay can severely stretch cash flow. 

At worst, the sales growth is not be sustained, and large quantities of stock (and staff) end up idly sitting in warehouses, causing a devastating impact on cash flow. Either way, you should steer clear of companies that report both profits and negative operating cash flows period after period.

Examine the company's cash burn rate (The rate at which a new company uses up its venture capital to finance overhead before generating positive cash flow from operations. In other words, it's a measure of negative cash flow). If a company burns cash too fast, it runs the risk of going out of business. Enron's cash flow fell from negative $90 million in Q1 2000 to a very troubling negative $457 million a year later.)

Debt Levels
Interest repayments place pressure on cash flow, and this pressure is likely to be exacerbated for distressed companies. Because they a higher risk of default to banks, struggling companies must pay a higher interest rate. Debt therefore tends to shrink  returns.

Total debt to equity (D/E) ratio is a useful measure of bankruptcy risk. It compares a company's combined long- and short-term debt to shareholders’ equity or book value. High-debt companies have higher D/E ratios than companies with low debt. According to debt specialists, companies with D/E ratios below 0.5 carry low debt. And that means that conservative investors will give companies with D/E ratios of 0.5 and above a closer look.

Consider Enron's debt-to-equity levels before it declared bankruptcy in Dec 2001. At year end Dec 2000, its D/E ratio stood at 0.9.  At June 2001, it grew to 1.1. Finally, its Sept 2001 quarterly report showed a D/E ratio of 1.4. Enron would have qualified as a risky debt prospect each time. At the same time, the D/E ratio does not always say much. It should be accompanied by an analysis of the debt interest coverage ratio. For example, say a company had a D/E ratio of 0.75, which signals a low bankruptcy risk, but it had an interest coverage ratio of 0.5.  An interest coverage ratio below 1 means that the company is not able to meet all of its debt obligations with the period's operating income, indicating that a company is having difficulty meeting its debt obligations.

Share Price Decline
The savvy investor should also watch out for unusual share price declines. Almost all corporate collapses are preceded by a sustained share price decline. Enron's share price started falling two years before it went bust. The same holds true for WorldCom.

A substantial share price decline might signal trouble ahead, but it may also indicate a valuable opportunity to buy an out of favor business with solid fundamentals. Knowing the difference between a company on the verge of collapse and one that is undervalued is not always straightforward. The other factors discuss below can help tell them apart.

Profit Warnings
Investors should take profit warnings (When a company advises its earnings won't meet analyst expectations) very seriously. While market reaction to a profit warning may appear swift and brutal, there is growing academic evidence to suggest the market systematically under reacts to bad news. As a result, a profit warning is often followed by a gradual share price decline.

Insider Trading
Companies are required to report, by way of company announcement, purchases and sales of shares by substantial shareholders and directors. Executives and directors have the most up-to-date information on the company's prospects, so heavy selling by one or both groups can be a sign of trouble ahead. While recommending that investors buy his company's stock, Enron's Chairman Kenneth Lay sold $123 million in shares in 2000. That was nearly three times his gains in 1999, and nearly 10 times what he made in 1998. Admittedly, insiders don't always sell simply because they think their shares are about to sink in value, but insider selling should give investors pause.

Resignations
The sudden departure of key executives or directors can also signal bad news. While the resignations may be completely innocent, they demand closer investigation. Warning bells should ring the loudest when the individual concerned has a reputation as a successful manager or a strong, independent director.

You should also be wary of the resignation or replacement of auditors. Naturally, auditors tend to jump ship at the first sign of corporate distress or impropriety. Auditor replacement can also mean a deteriorating relationship between the auditor and the client company, and perhaps more fundamental difficulties within the client's business.

Investigations
Formal investigations by the Securities and Exchange Commission (SEC) normally precede corporate collapses. That's not surprising since, many companies guilty of breaking SEC and accounting rules do so because they are facing financial difficulties. 

Unfortunately for most Enron and WorldCom investors, the SEC did not spot problems in these companies before it was too late. However, the SEC has a pretty good nose for detecting corporate and financial misdeeds. While many SEC investigations turn out to be unfounded, they still give investors good reason to pay closer attention to the financial situations of companies that are targeted by the SEC.

Conclusion
Just as a seriously ill person can make a full recovery and go on to lead a fulfilling life while a seemingly healthy person can drop dead without warning, some very sick companies can make miraculous recoveries while apparently thriving ones can collapse overnight. But the probability of this is very low. Typically, when a company is struggling, the warning signs are there. The best line of defense as an investor is to be informed - ask questions, do research, be alert to unusual activities. Make it your business to know a company's business and you will minimize your chances of getting caught in a corporate bust.