Are you worried that the stock of the company you own might be headed for trouble? there are three stock warnings that your stock might encounter trouble ahead.
Any shortfalls in the financial statements spell big trouble for shareholders. While trouble seems to come out of nowhere, there are early stock warnings that can indicate potential problems. Pay attention to these stock warnings by performing these simple analyses.
Gross profit margin analysis of a company is most useful for detecting deteriorating competitive conditions. The gross margin measures the profit a company makes on its products or services it sells before accounting for overhead, marketing, research and development, interest and taxes. When the gross profit margin rises, it tells you that the company is raising prices and/or reducing production costs. When the gross margins are rising, it is a sign of good future earnings surprises.
Conversely, gross profit margins that are shrinking indicate that price raises are not keeping up with cost and/or production costs are increasing faster than revenues. Either condition portends future earnings falls.
The gross profit margin is calculated by dividing gross operating profit by sales for the same period. Most companies provide the gross profit margin with their release of their quarterly and annual financial statements. Gross profit margin analysis gives you a quick way to identify a change in the gross margin. Moreover, seasonal factors can influence the gross margin, so be sure to include a comparison to the prior year’s numbers.
Accounts receivable analysis provides investors a way to see if there is a growing sales problem. When a company buys products or services from another, they usually do not pay cash. Rather, companies give their customers time to pay for the goods purchased, say 30, 60 or even 90 days. The amount owed by a customer is called accounts receivables. Normally accounts receivables track sales. If a company sells twice as much as it did a year ago, you should expect its receivables to double.
Sometimes sales grow faster than receivables, indicating that the firm is doing a better job of collecting its bills. This is a good thing.
On the other hand, when receivables rise faster than sales, it is a warning sign that there could be trouble. In performing your accounts receivable analysis, there are three reasons why this could happen:
All three are a problem. The first two are harder to fix and will result in sales and earnings shortfalls in the near future. Problem number three can be addressed through more effort to collect the company’s bills. However, it to can be a sign, customers are facing more difficult problems.
When performing accounts receivables analysis compare the ratio of accounts receivable on the balance sheet to sales on the income statement over time. This information is available from the companies quarterly financial statements. Use at least five quarters to get a proper trend. If there is a change in the trend of these two numbers, it raises a warning sign you stock might be in trouble.
Looking for a cash flow problem will help to determine if there is a growing problem with the company's performance. Cash flow is the most reliable measure of a company’s performance. Cash flow measures the movement of cash into and out of the company’s bank accounts during the reporting period. Since cash must be reconciled with actual balances in the company’s bank accounts, it is a more reliable measure of the company’s results. Management can manipulate reported earnings. In addition, accounting for earnings is subject to arbitrary rules, which can be interrupted differently. Cash flow is not subject to these problems. You might find some companies report higher earnings, yet they have falling operating cash flow.
Operating cash flow measures the change in bank balances from the operations of the company. Operating cash flow starts with net income and then removes the non-cash accounting entries such as depreciation. When you find a company that is reporting growing net income, yet shows falling operating cash flow it is a red flag. Ideally, operating cash flow should be growing at about the same rate as net income. If the cash flow number turns down while the net income number continues to rise, it maybe an early warning sign that the company is encountering a problem.
Relatively simple measures can warn investors of impending trouble. The data for these measures is readily available from the financial sites as well as from the company’s own SEC filings. Taking the time to assess the situation can save you heartache later. When you see these signs, it might be a good time to close sell before the news gets worse.
If you wish to learn more on how to analyze financial statements, I suggest reading:
Financial Statement Analysis and Security Valuation by Stephan Penman. Explains how to use financial statements to value companies. While expensive, this textbook is an excellent reference for any investor and will pay for itself very quickly.