5 Warning Signs From Companies in Trouble

As investors navigate the sometimes treacherous waters of investing, they periodically encounter companies that have gotten into financial trouble, either due to poor management, competition, or industry factors. Here are five warning signs to look for that signal a company may be in trouble. Remember that these red flags are signals for investors to dig deeper — on their own, they may not always signal a nagging, long-term problem.

1. Plunging margins

When a company experiences a sharp drop in either gross margins or operating margin, this is a sign that something may not be quite right. For gross margin declines, this implies the company may be slowly losing pricing power to competitors, while plunging operating margins signal poor expense control.

2. Ballooning trade receivables

Companies that sell goods or services on credit book something called trade receivables, which are then collected within a period of usually 60 to 90 days. When trade receivables rise or remain elevated without a corresponding increase in revenue, investors should become wary as this could mean the company may be having trouble collecting. If customers drag their feet and pay much later, it would affect the cash conversion cycle of the company. Worse, if the customers are unable to pay at all, the company would have to impair the receivables, which would directly hit profits.

3. Bloated inventories

A sharp build-up in inventory could signal that a company’s products may be selling more slowly, and it could point to possible obsolescence issues. Companies with a wide product range in a sunset industry are at risk of seeing this happen, so investors should keep a close eye on inventory levels. An exception is if the company is experiencing strong demand for its products and then show inventories spiking up temporarily as it ramps up production in anticipation of better sales.

4. Persistent negative operating cash flow

It’s normal for a company to report negative operating cash flows in certain quarters because of the nature of working-capital movements, where more capital may be needed at times. However, if a company should report persistent negative cash flows over a sustained period of time, it’s a big red flag as it may signal that the company is relying mainly on financing (i.e., bank loans) to sustain its everyday business activities.

5. Profits to losses

A final red flag to watch out for is when the company reports a loss when it has been profitable all along. If the loss is due to one-off events or exceptional items (such as a write-off of goodwill), then there is no cause for undue worry. But if the loss was due to poorer sales and a loss of market share to competitors, then investors should definitely sit up and take more notice.

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