As a financial advisor, it is your fiduciary responsibility to keep an eye on your client's investments, and be on the lookout for investments that might fail. In this article, we give you several tips that will help you tell if a company is on the verge of bankruptcy, or headed for some serious financial difficulties.
Tutorial: How To Analyze Earnings
Dwindling Cash or Mounting Losses
Companies that lose money quarter after quarter go through their cash fast. So take a look at the company's balance sheet, and see what its cash holdings are versus what they were last year. Maybe the company can dig itself out of a hole by issuing more stock or debt. But remember, that only ratchets up the pressure down the road. (For more warning signs that a company is in trouble, see Are Your Stocks Doomed?)
Interest Payments In Question
A company's income statement will show what it pays to service its debt. Can the company keep losing money, and report the sales it is reporting and still have enough left to make interest payments? Typically, you want to see a cushion. You want companies to have more than enough cash left over at the end of the day to keep its creditors at bay. But, in companies that are failing, or about to fail, that cushion gradually wanes, and they are just barely able to make their bills. (To keep reading about company financials, see Understanding The Income Statement, Breaking Down The Balance Sheet and What You Need To Know About Financial Statements.)
The current ratio (or cash ratio) is a calculation that aids in determining a company's ability to pay short-term debt obligations. It is calculated by dividing current assets by current liabilities. A ratio higher than one indicates that a company will have a high chance of being able to pay off its debt, whereas, ratios below one indicate that a company will not be able to pay off its debt. The acid-test ratio can also be used, the difference being its exclusion of inventory and prepaid accounts from current assets.
Switching Auditors or Going Concern Clause
All public companies must have their books audited by an outside accounting firm. And while it is not uncommon for companies to switch firms from time to time, an abrupt dismissal of an auditor or accounting firm for no apparent reason should raise red flags. It is usually a sign that there is some sort of disagreement over how to book revenue, or a conflict with members of the management team. Neither is a good sign.
Another thing to look for is the auditor's letter. As part of the proxy statement (companies also sometimes include this information in 10-Ks and annual reports), auditors will write a letter stating that they believe that the income, cash flow or balance sheet information was presented fairly, and accurately describes the company's financial status, at least to the best of its knowledge. However, if an auditor questions if the company has the ability to continue "as a going concern," or notes some other discrepancy in accounting practices, specifically how it books revenue, that should also serve as a serious warning sign.
Companies that reduce, or eliminate, their dividend payments to shareholders are not necessarily on the verge of bankruptcy. However, when companies go through tough times, dividends are usually one of the first items to go. Therefore, view cuts or the elimination of a dividend as a possible sign that some difficult times may be ahead.
It's important to consider other supporting evidence in determining whether a dividend cut is signaling dark times for a company. Namely, watch for declining or variable profitability, a high dividend yield when compared to other companies in the same industry, and negative free cash flow. (To read more on this subject, see Is Your Dividend At Risk?)
Top Management Defections
Did you ever see the movie "Titanic?" Remember when the ship was sinking, and there was a scene that showed all of the rats on the lower decks heading for higher ground?While this may not be the most politically correct analogy, it demonstrates what usually happens when a company is sinking. Remember, these folks, like you and I, want or need to work. So, when things are heading seriously downhill, you will start to see senior members of the management team bail and take a job at a different company. In the meantime, current employees with less seniority will take the senior executives' places.
Big Insider or Institutional Sales
The smart money investors, meaning institutional and executive holders of the stock, typically dump their shares ahead of a bankruptcy filing or really difficult times. This goes back to my rat sinking ship analogy. Be on the lookout for big sales by these smart money people as they may be a harbinger.
One thing though: During the normal course of business, some of these smart money players may sell the stock from time to time. In fact, it is perfectly normal. Essentially, you should pay attention to unusually large or frequent transactions, particularly those that occur in or around the time negative news is released.
Selling Flagship Products, Equipment or Property
If you were going through some tough times, you would probably tap your savings. And when you went through that, you would probably consider selling some of your assets to raise money. But you wouldn't sell your personal mementos unless you had to, right? Well, the same thing applies to a company. So, if you see the company selling off its headquarters, one of its big-name products or a sophisticated piece of equipment in order to raise cash, watch out!
Big Perk Cuts
Usually before the big problems begin, companies will seek to make deep cuts in their health benefits, pension plans or other perks. Deep and sudden cuts, particularly when they take place in conjunction with any of the other above-mentioned issues are a sign that trouble may lie ahead. Watch for these items to be in a news release or the annual prospectus. (To learn more, read Don't Forget To Read The Prospectus!)
The Bottom Line
It is not uncommon for companies to hit bumps in the road, and have to tighten their belts a little. However, if a company is tightening that belt excessively, or if more than one of the above scenarios occurs, beware.