3 Warning Signs of a Troubled Company

There are more than 700 companies listed in Singapore at the moment. Given this large number, it can be assumed that there are bound to be companies which are in distressed states at any one point in time.

The question is, how can we possibly differentiate between the ones which are mired in real trouble from the ones which are merely facing temporary challenges? The distinction is important because the former can be a recipe for poor returns while the latter may prove to be lucrative investing opportunities.

Here a few yellow flags to look out for when it comes to identifying companies which fall into the category of a company mired in real trouble.

1. Negative cash flow

Legendary investor Warren Buffett has never been shy about letting it be known that his idea of a great company is one that has the ability to generate copious amounts of cash flow for its shareholders.

This is also good advice when it comes to finding traps in the stock market: A company which is consistently unable to generate positive cash flow for its shareholders might be a cause for concern.

Cosco's operating cash flow and total debt from 2009 to 2014

Source: S&P Capital IQ

One such company is Cosco Corporation (Singapore) Limited (SGX: F83). The shipbuilder has been generating negative cash flows from its operation since 2009 as you can see in the chart above. To fund its business, Cosco has had to raise its borrowings in nearly every year; this is also shown in the same chart above and leads me to the second sign of a trouble company.

2. High debt levels

Debt is a double-edged sword for a business. A company with a high leverage ratio might be able to increase its return on equity significantly during good times and thus benefit its shareholders. However, a highly-levered firm might also face financial difficulties during hard times, such as struggling to keep up with interest payments or an inability to repay due-debt.

A company with a very high level of debt currently is property developer Oxley Holdings Limited (SGX: 5UX). Based on its last reported financials, its net-debt to equity ratio (where net-debt refers to total borrowings minus total cash) is nearly 390% and its interest coverage ratio (EBIT/Interest Expense) is only 3.4.

Those figures paint a picture of a firm that has very little room for error when it comes to dealing with any slowdown or unforeseen hiccup in its business environment.

3. Negative research reports

Another possible sign of a troubled firm is one which has been publicly attacked by research firms regarding the health of their financials. Companies such as Olam International Limited (SGX: O32) and Noble Group Limited (SGX: N21) have both been attacked by research firms on the basis of, among other issues, their balance sheets being weaker than it seems on the surface (see more of Noble’s problems in here).

While the research firms may or may not be right, any attacks by them on a company are signs that investors should dig a little deeper to truly understand what is happening within a firm before any investment decisions are made.

Foolish Summary

Of course – not all companies that have these characteristics are in real trouble. In fact, the companies mentioned above – Cosco, Oxley, Olam, and Noble –are not necessarily facing any painful issues now too.

But, it is better for investors to undertake a deeper investigation into companies that display these warning signs in order to be sure that they are not facing a structural decline in their businesses.

In any case, with so many other companies available to invest in Singapore’s stock market, it might be wiser for investors to just avoid the companies with the yellow flags and focus on companies that have clearly superior business models, balance sheets, and ability to generate cash flow.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore writer Stanley Lim doesn’t own shares in any companies mentioned.