Chapter 25

Ten Signs That a Company's in Trouble

In This Chapter

Keeping an eye on a company's financial numbers

Examining a company's methods and procedures

If you don't recognize traffic signs, driving is going to be pretty hairy. By the same token, if you don't recognize a company's danger signs by reading the financial reports, your investment decisions may not be the best ones.

Many companies put out glossy financial reports more than 100 pages long with the most graphically pleasing sections providing only the news about the company that its managers want you to read. Don't be fooled. Take the time to read the pages in smaller print and the ones without the fancy graphics, because these pages are where you find the most important financial news about the company. The following are key signs of trouble that you may find within these pages.

Lower Liquidity

Liquidity is the ability of a company to quickly convert assets to cash so that it can pay its bills and meet other debt obligations, such as a mortgage payment or a payment due to bond investors. The most liquid asset a company holds is cash in a checking or savings account. Other good liquid sources are holdings that a company can quickly convert to cash, such as marketable securities and certificates of deposits.

Other assets take longer to turn into cash, but they can be more liquid than long-term assets, such as a building or equipment. Take, for instance, accounts receivable. Accounts receivable can often be liquid holdings, provided that the company's customers are paying their bills on time. If customers are paying their bills late, the company's accounts receivable are less liquid, meaning that it takes longer for the company to collect that cash. I show you how to test a company's accounts receivable management in Chapter 16.

Another sign of trouble may be inventory. If a company's inventory continues to build, it may have less and less cash on hand as it ties up more money in the products it's trying to sell. I show you how to test a company's inventory management in Chapter 15, and I show you how to measure a company's overall liquidity in Chapter 12.

Low Cash Flow

If you don't have cash, you can't pay your bills. The same is true for companies. You need to know how well a company manages its cash, and you can't do that just by looking at the balance sheet and income statement, because neither of these statements reports what's actually happening with cash.

The only way you can check out a company's cash situation is by using the cash flow statement. I show you numerous ways to test a company's cash flow in Chapter 13. After doing the calculations in Chapter 13, if you find that a company can't meet its cash obligations or is close to reaching that point, this situation is a clear sign of trouble.

Disappearing Profit Margins

Everyone wants to know how much money a company makes — in other words, its profits. A company's profit dropping year to year is another clear sign of trouble.

Companies must report their profit results for the current year and the two previous years on their income statements, one of the three key financial statements that are part of the financial reports. (See Chapter 7 for more information about income statements.) When investigating a company's viability, looking at the past five years or more — if you can get the data — is a good idea.

Luckily, finding a company's historical profit data isn't hard. In the investor relations section on their website, most companies post financial reports for the current year and two or more previous years. The Securities and Exchange Commission (SEC) also keeps previous years’ reports online at Edgar (www.sec.gov/edgar.shtml).

Anytime you notice that a company's profit margins have fallen from year to year, take it as a clear sign that the company is in trouble. Research further to find out why, but definitely don't invest in a company with falling profit margins unless you get good, solid information about an expected turnaround and how the company plans to pull that off. To find out more about how to test whether a company is making a profit, turn to Chapter 11.

Revenue Game Playing

A day rarely goes by when you don't see a story about company bigwigs who've played with their firm's revenue results. Although the number of companies being exposed for revenue problems has certainly fallen since the height of scandals set off by the fall of Enron in 2001, a steady stream of reporting about the games companies play with their revenue continues.

Problems can include managing earnings so results look better than they really are and actually creating a fictional story about earnings. I talk more about how companies play games with their revenue numbers in Chapter 23.

Unfortunately, the only way that a member of the general public can find out about these shenanigans is from the financial press. If the SEC or one of the country's state attorneys general begins an investigation, you likely won't know about it until the financial press decides to report on it. The SEC does post details about its investigations at www.sec.gov/litigation.shtml. Usually, by the time that info is posted, the financial press has already done a story.

The initial stages of an investigation usually involve private inquiries between the SEC and the company regarding financial information filed on one of the SEC's required forms. (For more information about those forms, see Chapter 19.) These initial inquiries aren't discussed publicly. Only after the SEC decides that a company isn't cooperating does it start a formal investigation. When the SEC does start a formal investigation, the company must put out a press release to inform the general public (as well as its investors, creditors, and others interested in the company) that the SEC has some questions about the company's financial reports.

Too Much Debt

Borrowing too much money to continue operations or to finance new activities can be a major red flag that indicates future problems for a company, especially if interest rates start rising. Debt can overburden a company and make it hard for the business to meet its obligations, eventually landing it in bankruptcy.

You can test a company's debt situation by using the ratios I show you in Chapter 12. These ratios are calculated using numbers from the balance sheet and income statement. Compare a company's debt ratios with those of others in the same industry to judge whether the company is in worse shape than its competitors.

Unrealistic Values for Assets and Liabilities

Some firms can make themselves look financially healthier by either overvaluing their assets or undervaluing their liabilities. Overvalued assets can make a company appear as if its holdings are worth more than they are. For instance, if customers aren't paying their bills but the accounts receivable line item isn't properly adjusted to show the likely bad debt, accounts receivable will be higher than they should be. Undervalued liabilities can make a company look as though it owes less than it actually does. An example of this is debts moved off the balance sheet to another subsidiary, to hide the debt. That tactic is just one of the ways Enron and other scandal-ridden companies tried to hide their problems. If a firm hides its problems well to offset the overvaluing of assets or the undervaluing of liabilities, equity is probably overstated as well.

If you suspect a company of either possibility, it's a clear sign of trouble ahead. Certainly, you can begin to suspect a problem if you see stories in the newspapers about the SEC or state authorities raising questions regarding the company's financial statements. You may be able to spot problems sooner by using the techniques I discuss in Chapter 23.

A Change in Accounting Methods

Accounting rules are clearly set in the generally accepted accounting principles (GAAP) developed by the Financial Accounting Standards Board (FASB). You can find details about the GAAP at the FASB's website (www.fasb.org). Sometimes a company can file a report that's perfectly acceptable by GAAP standards, but it may hide a potential problem by changing its accounting methods. For example, all firms must account for their inventory by using one of five methods. Changing from one method to another can have a great impact on the bottom line. To find out whether this kind of change has occurred, read the fine print in the financial notes. I talk more about accounting methods in Chapter 4 and delve deeper into inventory control methods in Chapter 15.

Questionable Mergers and Acquisitions

Mergers and acquisitions can be both good news and bad news. Most times, you won't know whether a merger or acquisition will actually be good for a company's bottom line until years later, so be careful buying into the fray when you see stories about the possibility of a merger or acquisition.

If you don't already own the stock, stay away until the dust settles and you get a clear view of how the merger or acquisition will impact the companies involved. If you do own shares of stock, you'll be able to vote for or against the merger or acquisition if it involves the exchange of stock. You can get to know the issues by reading what the company sends out when it seeks your vote. Follow the stories in the financial press, and read reports from analysts about the merger or acquisition.

You don't see much about mergers and acquisitions in the three key financial statements (income statement, balance sheet, and statement of cash flows); they rarely take up more than a line item. The key place to find out about the impact of mergers and acquisitions is in the notes to the financial statements, which I talk more about in Chapter 9.

I can't tell you how to read the tea leaves and figure out whether a merger or acquisition is ultimately a good idea, but I can warn you to stay away if you don't already own the stock. If you're a shareholder who will eventually have to vote on the merger or acquisition before it can be approved, I urge you to read everything you can get your hands on that discusses the financial impact the merger or acquisition may have on the company.

Slow Inventory Turnover

One way to see whether a company is slowing down is to look at its inventory turnover (how quickly the inventory the company holds is sold). As a product's life span nears its end, moving that product off the shelf tends to be harder.

When you see a company's inventory turnover slowing down, it may indicate a long-term or short-term problem. Economic conditions, such as a recession — which isn't company specific — may be the cause of a short-term problem. A long-term problem may be a product line that isn't kept up-to-date, causing customers to look to other companies or products to meet their needs. I show you how to pick up on inventory turnover problems in Chapter 15 by using numbers from the income statement and balance sheet.

Slow-Paying Customers

Companies report their sales when the initial transaction occurs, even if the customer hasn't yet paid cash for the product. When a customer pays with a credit card issued by a bank or other financial institution, the company considers it cash. But credit issued to the customer directly by the company selling the product isn't reported as cash received. The reason is that the customer doesn't have to pay cash until the company that issues the credit bills him. For example, if you have an account at Office Depot for charging your office supplies, Office Depot doesn't get cash for those supplies until you pay your monthly statement. If, instead, you buy those same supplies using a Visa or MasterCard, the credit card company deposits cash into Office Depot's account and then works to collect the cash from you.

Businesses track noncash sales to customers who buy on credit in an account called accounts receivable. Customers are billed for payments, but not all customers pay their bills on time. If you see a company's accounts receivable numbers continuing to rise, it may be a sign that customers are slowing their payments; eventually, the company may face a cash flow problem. See Chapter 16 to find out how to detect accounts receivable problems.