What Is A Good Price To Free Cash Flow Ratio 10 Red Flags in Financial Statement Filings

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10 Red Flags in Financial Statement Filings

In this article, we’ll use the data described in our analysis of the income statement, balance sheet, and cash flow statement to identify 10 “red flags” to look out for. These red flags may indicate that a company may not be an attractive investment based on three main pillars: growth potential, competitive advantages, and strong financial health. Conversely, a company with few or none of these red flags is probably worth considering.

The red flags, in no particular order, are:

  1. Perennial trend of declining income.

    While a company can improve profitability by eliminating wasteful spending, reducing unnecessary headcount, improving inventory management, and so on, long-term growth depends on sales growth. A company with 3 or more consecutive years of declining revenue is a questionable investment – any cost efficiencies can usually be realized in that time period. More often than not, a decrease in income is an indicator of a declining business – rarely a good investment.

  2. A multi-year downward trend in gross, operating, net and/or free cash flow margins.

    Falling margins may mean the company is becoming bloated or that management is pursuing growth at the expense of profitability. This should be taken in context. A declining macroeconomic picture or a cyclical company can lower margins without indicating an intrinsic decline in business. If you can’t reasonably attribute the margin weakness to external factors, be cautious.

  3. Excessively growing number of remaining shares.

    Keep an eye out for companies whose stock numbers are consistently growing more than 2-3% per year. This means that the management leaves the company and dilutes your stake through options or secondary stock offerings. The best case here is to see the share count decreasing 1-2% per year, which shows that management is buying back shares and increasing your stake in the company.

  4. A rising debt-to-equity ratio and/or a falling interest coverage ratio.

    Both are indicators that the company is borrowing more than its operations can handle. While there are few tough goals in investing, take a closer look if your debt-to-equity ratio is greater than 100% or your interest coverage ratio is 5 or less. Take a closer look to see if this red flag is accompanied by a drop in sales and/or margins. If so, this stock may not be in good financial shape. (Interest coverage is calculated as: net interest payments / operating income).

  5. Growing accounts receivable and/or inventory, as a percentage of sales.

    The purpose of business is to create money from assets – period. When accounts receivable grow faster than sales, it means customers need more time to give you cash for products. When inventory is growing faster than sales, it means your company is producing products faster than they can be sold. In both cases, the cash is tied up in places where it cannot earn a return. This red flag can indicate poor supply chain management, poor demand forecasting and overly loose credit terms for customers. As with most of these red flags, look for this phenomenon over a period of several years, as short-term problems are sometimes caused by uncontrollable market factors (like today).

  6. Free cash to earnings ratios consistently below 100%.

    This is closely related to the red flag above. If free cash flow consistently falls below reported earnings, a serious investigation is warranted. Usually, rising accounts receivable or inventory is the culprit. However, this red flag can also be an indicator of accounting tricks such as capitalizing purchases instead of expenses, which artificially inflates the net income number on the income statement. Remember, only the cash flow statement shows discrete monetary values ​​- everything else is subject to accounting “assumptions”.

  7. Very large “Other” items in the income statement or balance sheet.

    This includes “other expenses” in the income statement and “other assets”/”other liabilities” in the balance sheet. Most companies have them, but the value given to them is small enough not to cause concern. However, if those line items are significant as a percentage of the total business, investigate what is included. Are the costs likely to recur? Are any of these “other” items suspicious, such as related party transactions or non-business related items? Large “other” items can be a sign that management is trying to hide things from investors. We want transparency, not shadow.

  8. Lots of non-operating or non-recurring expenses on the income statement.

    Good companies have very easy to understand financial statements. On the other hand, companies trying to play off or hide problems often bury expenses in the “other” categories above, or add numerous line items for things like “restructuring,” “asset impairment,” “goodwill impairment,” and so on. Several years of the pattern of these “one-off” fees is worrying. Management will tout its improvement in non-GAAP, or pro-forma, results — but the improvement is actually little. These fees are a way of confusing investors and trying to make things look better than they are. Look at the cash flow statement instead.

  9. Current ratio below 100%, especially for cyclical companies.

    This is another measure of financial health, calculated as (current assets / current liabilities). This measures the liquidity of companies or their ability to meet their obligations in the next 12 months. A current ratio below 100% is not a big concern for companies that have stable operations and generate a lot of cash (think Proctor and Gamble (PG)). But for highly cyclical companies that could see 25% of their revenue disappear in one year, that’s a big concern. Cyclic + low current ratio = recipe for disaster.

  10. Poor return on capital when goodwill is added.

    This one is especially intended for Magic Formula investors. Joel Greenblatt’s The Little Book that Beats the Market removes goodwill for purposes of calculating return on capital. However, if growth is financed by overpaying acquisitions, the return on equity will look great because the overpayment amount is not calculated. MagicDiligence always looks at both measures, with and without goodwill. If the “goodwill” number is low, the MFI’s high return on equity is a mirage.

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