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3 Red Flags to Look out for in Financial Statements

A company’s financial statement can tell us many things about the company. It can give us an idea about the company’s profitability and financial well-being. We can also spot companies that may be risky investments just by looking at their balance sheet and cash flow statements.

Here are three red flags all investors should be able to spot when looking at a company’s financial health.

Recent history of declining earnings

Companies may at times face challenges that can result in short-term profit declines. However, if the problem persists and companies consistently report declining profits and margins over a substantial period, it could mean the company has not been able to keep up with the times.

This is especially common now where technological disruptions have caused many companies to falter. One such area is the retail industry, where e-commerce has eaten substantially into their market share.

Numerous prominent retail companies that used to thrive in the 1990s and early 2000s have been hit hard, and some have eventually folded. Investors need to keep a lookout for companies that may be facing similar problems.

Overly leveraged

Companies often borrow money to fund their operations and investments. Borrowing money allows companies to achieve much higher returns on equity and make bigger investments for the future.

However, too much borrowing can also be extremely dangerous for a company. If there are any unforeseen circumstances in the business and the company is unable to pay up its debt, then shareholders will suffer. It can also result in companies closing down due to inability to pay off its creditors.

As such, investors need to be extremely wary of such scenarios. A good way to assess if a company is taking on too much debt is by using the current ratio, which is current assets divided by current liabilities. A ratio below one may mean that the company does not have enough short-term capital to pay off its short-term debt.

Consistently negative cash flow

Cash is the lifeblood of a company. Therefore, companies need to be able to generate cash consistently over time. A company that is profitable but is unable to generate cash in the long-term will face severe cash flow issues over time.

Having cash on hand also means the company will be able to make investments in the future and can expand its business if it chooses to do so.

The Foolish bottom line

Before making any investment in stocks, it is important that investors know the red flags to look out for. If any of the red flags mentioned above are present in a company, investors should be cautious about investing in it.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice.