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How to Know If Your Investments Have Turned Sour?

As investors, we should continually be on the lookout for signs that tell us our investments may not be doing as well as they should be, as this may invalidate our original investment thesis.

The difficulty here is in assessing what constitutes “business deterioration”, as the term itself is broadly used to define any situation in which a company displays certain financial or operating traits. I will look at a few methods to assess business decline and also discuss how investors should perceive the decline and react accordingly.

Assessment – Deterioration In Financial Or Operational Metrics

In assessing if a business has suffered from a decline or deterioration, investors should look out for a combination of financial and operating metrics. A few of these are stated below for easy reference:-

Financial Metrics
• Decline in gross margins, operating margins or net margins
• An increase in total debt or an increase in the debt-equity ratio
• Negative operating cash flow or free cash flow
• A decline in profits or seeing losses when the company previously reported profits

Operational / Other Metrics
• A significant decline in market share
• Negative same-store sales numbers (for the retail industry)
• Falling factory production utilisation
• Increase in staff turnover rate

Frequency, Severity And Duration

After identifying the metrics which have deteriorated, the next step for the investor would be to assess both the i) frequency; ii) severity; and iii) duration of the declines.

Frequency is important in assessing if the decline is just temporary (i.e. one-off) or if this may signal a structural deterioration in the business environment surrounding the company. For example, a company reporting negative free cash flow for just one quarter could state that it was due to changes in working capital, but if a company reports consistent negative free cash flow for three years in a row, investors should sit up and take notice.

Severity would indicate the magnitude of the decline, and whether this is material to the business or not. For example, a one percentage point decline in gross margins is probably nothing to worry about, but if the decline was five or more percentage points, investors should probably investigate further.

Duration would refer to how long the decline lasts for — is it just limited to a short period of time or is the problem persistent? If there is a persistent deterioration in certain metrics, investors should treat these as serious red flags and investigate deeper.

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