There are important phrases that investors need to recognize as major red flags. Unfortunately, in filings made to the Securities and Exchange Commission (SEC) and legal boilerplates, companies often try to obscure these phrases in an attempt to lessen their impact on the market. Fortunately, by recognizing a few key phrases, casual readers will be alert to some very important information that will help avoid investment mistakes. One of these key phrases is "material adverse effect".

Here we'll take a look at what this statement means and why investors shouldn't miss it.

Tutorial: Advanced Financial Statement Analysis

Intro to Material Adverse Effect
A material adverse effect usually signals a severe decline in profitability and/or the possibility that the company's operations and/or financial position may be seriously compromised. This is a clear signal to investors that there is something wrong.

For example, suppose that Industrial Blowdart Inc. has a major customer that represents 25% of annual sales. If that client takes its business elsewhere, the decision will have a material adverse impact on Blowdart's sales, profitability and ability to stay in business. The company's material adverse effect might read as follows:

"One customer accounts for more than 25% of our annual sales. The loss will have a material adverse effect on Blowdart's profits and will remain an ongoing concern."

Or, suppose that Blowdart has a critical line of credit that it uses to finance working capital (i.e. inventory or accounts receivable). If the bank refuses to renew the line of credit, the difficulty and/or inability to find another lender will have a material adverse impact on Blowdart's operating cash flow and ability to operate normally, let alone continue as a viable business.

Generally accepted accounting principles (GAAP) allow flexibility in determining what must be defined and disclosed as a material adverse event. However, despite SEC action in 1999 and the increased scrutiny that companies are under, many continue to use their own definitions in order to manage earnings.

Materiality: If It Matters, It's Material
A piece of information is material if it is reasonable to expect that disclosure of that information will impact the company's stock price. Companies and their accountants continue to find ways to manage earnings by coming up with their own definitions of materiality. This involves establishing a numerical threshold (say, 5%) and deciding that anything that falls below the threshold will not impact the bottom line, is immaterial and thus does not require discussion. There are also cases in which companies, in order to hide their mistakes, net items against each other to keep below their numerical thresholds. The reason for this deception is earnings management. (To learn more, read What is earnings management?)

In 1998 the SEC brought a case against W.R. Grace & Co. (NYSE:GRA), claiming that from 1991 to 1995, the company used a $60 million "reserve" of immaterial items to smooth earnings - with the full knowledge of the company's auditors. The SEC alleged that this use of reserved was not in line with GAAP. In 1999, W.R. Grace agreed to cease and desist its use of this practice, and pay $1 million into a fund related to education in GAAP.

Unfortunately, many companies continued to net immaterial items in order to hit earnings targets. The netting takes place in the Other Income/Expense line of the income statement. Items that are used to net are gains/losses on investments and restructuring reserves.

In 1999, the SEC attempted to prevent companies from hiding material items by establishing the following rules:

  • An intentional misstatement, even if it involves an immaterial amount, is material because of the intent to mislead.
  • Numerical thresholds alone are unacceptable.
  • Management must also weigh qualitative matters if the misstatement will hide a change in earnings or concerns a key business segment.
  • The company cannot net items. Netting results in a misstatement of the company's financial statement.

Not an Early Warning Signal
Material adverse effect is not an early warning signal, but rather a sign that a situation has already deteriorated to a very bad stage. Usually, this is the result of an accumulation of events over time that compound to a point where a critical limit is crossed. Closely following a company's operating results over time will alert investors to potential material adverse effects. This kind of awareness requires a great deal of effort, time and experience.

Assume, for example, that Blowdart's financial condition has deteriorated to the point where it is in default of its loan covenants. This is a material adverse event because it means that if the company and the bank cannot agree on how to restructure the loan, the loan could be called, requiring immediate repayment. This would put Blowdart out of business.

If you followed Blowdart stock, you would know it was having problems. You would also have to dig through the SEC filings to find the loan agreements and then read those complex documents in order to find the relevant loan covenants and the metrics used to determine whether the borrower was in compliance or default.

It is possible that Blowdart and its bankers can restructure the loans and get the company through the difficult times. Conversely, if the bank wants to exit the relationship, Blowdart needs to find another lender, which may not be easy to do because of the company's recent operating history and/or current adverse economic conditions.

In this hypothetical situation, investors need to review this stock in light of their own risk aversion profiles. While the outcome might even be 60/40 in favor of a successful loan renegotiation, you may not want to deal with the added risk. If so, sell the stock. However, if you have studied the company and industry closely and feel that there are some strong fundamental reasons for owning the stock for the long term, you may decide to hang on to it.

Where to Find Material Adverse Effect Statements
Government regulations require companies to disclose material events. The phrase material adverse effect can be found in the following:

  • The notes to financial statements, referred to as footnotes, found in a company's 10-Qs and 10-Ks and in the auditor's opinion, which relate to the issue that could cause the material adverse effect. For example, the material adverse effect statement would appear in Blowdart's financial statement notes that discuss accounts receivables, or customer concentration and its debt and credit facilities. (For more on this, see Footnotes: Start Reading The Fine Print.)
  • Press releases may contain a material adverse effect phrase if the release deals with financing issues or if the company is announcing a material event.
  • The management's discussion and analysis (MD&A) in a company's annual report may contain some reference to the material adverse effect.

Discussing every business detail in a company's financial statements is difficult. A balance is needed between required disclosures and tedious reporting burdens. Corporations should stay on the side of over-disclosure because investors value more than the illusion of steady earnings.

Related Articles
  1. Investing News

    Obama Wants to Double Wall Street Regulation

    President Obama wants to double the budgets of the SEC and the CFTC over the next five years.
  2. Taxes

    Why People Renounce Their U.S Citizenship

    This year, the highest number of Americans ever took the irrevocable step of giving up their citizenship. Here's why.
  3. Personal Finance

    What it Takes to Get a Green Card

    Grounds for getting a green card include having family members in the U.S., being a certain type of refugee or specialized worker, or winning a lottery.
  4. Economics

    Understanding Cost-Volume Profit Analysis

    Business managers use cost-volume profit analysis to gauge the profitability of their company’s products or services.
  5. Fundamental Analysis

    5 Must-Have Metrics For Value Investors

    Focusing on certain fundamental metrics is the best way for value investors to cash in gains. Here are the most important metrics to know.
  6. Fundamental Analysis

    5 Basic Financial Ratios And What They Reveal

    Understanding financial ratios can help investors pick strong stocks and build wealth. Here are five to know.
  7. Investing News

    ABC's Madoff Miniseries Explores His Charm, Smarm

    An ABC miniseries on Ponzi scheme king Bernie Madoff gets inside the head of a man who was, in fact, not too big to fail.
  8. Stock Analysis

    Analyzing Google's Return on Equity (ROE) (GOOGL)

    Learn about Alphabet's return on equity. How has its ROE changed over time, how does it compare to its peers and what factors are driving ROE for the company?
  9. Stock Analysis

    The Top 5 Micro Cap Alternative Energy Stocks for 2016 (AMSC, SLTD)

    Follow a cautious approach when purchasing micro-cap stocks in the alternative energy sector. Learn about five alternative energy micro-caps worth considering.
  10. Stock Analysis

    Analyzing Porter's Five Forces on Under Armour (UA)

    Learn about Under Armour and how it differentiates itself in the competitive athletic apparel industry in light of the Porter's Five Forces Model.
  1. What items are considered liquid assets?

    A liquid asset is cash on hand or an asset that can be readily converted to cash. An asset that can readily be converted ... Read Full Answer >>
  2. What is the formula for calculating EBITDA?

    When analyzing financial fitness, corporate accountants and investors alike closely examine a company's financial statements ... Read Full Answer >>
  3. What is the formula for calculating the debt-to-equity ratio?

    Expressed as a percentage, the debt-to-equity ratio shows the proportion of equity and debt a firm is using to finance its ... Read Full Answer >>
  4. How do I calculate the P/E ratio of a company?

    The price-earnings ratio (P/E ratio) is a valuation measure that compares the level of stock prices to the level of corporate ... Read Full Answer >>
  5. How do you calculate return on equity (ROE)?

    Return on equity (ROE) is a ratio that provides investors insight into how efficiently a company (or more specifically, its ... Read Full Answer >>
  6. How do you calculate working capital?

    Working capital represents the difference between a firm’s current assets and current liabilities. The challenge can be determining ... Read Full Answer >>
Hot Definitions
  1. Socially Responsible Investment - SRI

    An investment that is considered socially responsible because of the nature of the business the company conducts. Common ...
  2. Presidential Election Cycle (Theory)

    A theory developed by Yale Hirsch that states that U.S. stock markets are weakest in the year following the election of a ...
  3. Super Bowl Indicator

    An indicator based on the belief that a Super Bowl win for a team from the old AFL (AFC division) foretells a decline in ...
  4. Flight To Quality

    The action of investors moving their capital away from riskier investments to the safest possible investment vehicles. This ...
  5. Discouraged Worker

    A person who is eligible for employment and is able to work, but is currently unemployed and has not attempted to find employment ...
  6. Ponzimonium

    After Bernard Madoff's $65 billion Ponzi scheme was revealed, many new (smaller-scale) Ponzi schemers became exposed. Ponzimonium ...
Trading Center