Red Flag

What is a 'Red Flag'

A red flag is an indicator of potential problems with a security, such as any undesirable characteristic that stands out to an analyst as it pertains to a company's stock, financial statements or negative news reports. Because there are many different methods used to pick stocks and investments, there are many different types of red flag. A red flag for one investor might be desirable to another, as in the example of how low institutional ownership might be a positive for someone looking for undiscovered companies but a negative for a pension fund that searches out blue chips.

BREAKING DOWN 'Red Flag'

There is no universal standard for identifying red flags. The method used to detect problems with an investment opportunity depends on the research methodology an investor employs.

Problems With Financial Statements

Regarding publicly traded companies, red flags may appear in quarterly financial statements compiled by a company's chief financial officer, auditor or accountant. These red flags may indicate some financial distress or underlying problem within the company. Unfortunately, red flags may not be readily apparent on a financial statement, and it may take some extra digging to get to the root of the problem. Red flags usually appear consistently in reports for several quarters in a row, but a good rule of thumb is to examine three years' worth of reports to make an informed investment decision.

Examples of Red Flags

Investors can look at revenue trends to spot a company's growth potential. Several quarters in a row of downward-trending revenue can spell doom for a company. Measures needed to rectify the situation aren't good either if a company needs to lay off employees or cut wasteful spending.

When a company takes on more debt without adding value to the business, the debt-to-equity ratio could rise above 100%. This could point towards cash flow problem as the business may have trouble paying down its debts on a regular basis.

A large stockpile of cash on hand doesn't necessarily denote a healthy company. A business that moves cash up and down, on a regular basis, indicates buying raw materials and then selling a finished product. Large amounts of cash may show accounts are being paid but no new money is coming into the firm.

Rising accounts receivables and high inventories may mean a company is having trouble selling its products or services. If this trend continues for several quarters, investors have to ask themselves why the company seems to be unable to empty its warehouses.

Due Diligence

The best way investors can avoid making a bad decision is to pay attention to red flags on financial statements. That's where expert analysis comes into play — amateur investors might consider reading expert analysis on various companies to make an informed selection about a stock, security or business opportunity.

RELATED TERMS
  1. Red

    A term relating to a negative balance on a company's financial ...
  2. Adverse Opinion

    A professional opinion made by an auditor indicating that a company's ...
  3. Red Chip

    A company based in Mainland China that is incorporated internationally ...
  4. Cash Flow Statement

    One of the quarterly financial reports any publicly traded company ...
  5. Credit Watch

    A variety of special programs offered by credit rating agencies ...
  6. Working Capital

    Working capital is a measure of both a company's efficiency and ...
Related Articles
  1. Investing

    Look For These Red Flags In The Income Statement

    Companies can overstate their revenues and understate their losses to boost investor confidence. Learn how to spot the these red flags in income statements.
  2. Investing

    The Next 48 Hours Are Critical To Your Financial Future

    Today could be critical to your financial future. The red flags I'm seeing right now are eerily similar to what I saw before several major corrections. If my hypothesis holds true, then the next ...
  3. Markets

    4 Bullish Flag Patterns You Should Trade Now

    Here are four stocks with flag patterns, highlighting the various ways to trade this chart pattern.
  4. Retirement

    Avoid An Audit: 6 "Red Flags" You Should Know

    Don't make yourself a target - steer clear of these attention-grabbing tax-filing practices.
  5. Investing

    The Major Warning Flag Most Investors Are Missing

    A week ago, I warned that an event was taking place that could spark the biggest correction since 2008. That day, the S&P 500 plunged 1.7% and the VIX shot up 22%. While traders panicked, ...
  6. Investing

    Financial Statements: Conclusion

    By David Harper (Contact David)Let's summarize the ideas discussed throughout this tutorial according to a few major themes:Let the Business Model Shape Your Focus AreasThe average 10-K annual ...
  7. Investing

    Signs That It Might Be Time To Sell

    In the stock market, knowing when to sell is just as important as knowing when to buy.
  8. Trading

    Profiting From Carry Trade Candidates

    Capitalize on the yield of the interest rate differential by using flags and pennants.
  9. Investing

    Advanced Financial Statement Analysis

    Learn what it means to do your homework on a company's performance and reporting practices before investing.
  10. Investing

    The Last Time This Happened The Market Fell Double-Digits

    I consider myself lucky to have begun my career before the catastrophe of the dot-com crash. I got to see up close what a boom and bust looks like. As a 20-year-old on the Philadelphia trading ...
RELATED FAQS
  1. What are red flags in a company's days sales of inventory?

    Consider what red flags an investor or lender might be able to determine about a company when examining its days sales of ... Read Answer >>
  2. What are the most common continuation patterns?

    Learn more about three of the most common types of continuation patterns – triangles, pennants and flags -- and how to differentiate ... Read Answer >>
  3. What information should I look at on a publicly traded company for use in fundamental ...

    Learn what information is important in fundamental analysis of a publicly traded company and how to use it to assess the ... Read Answer >>
  4. What are the fundamental differences between a pennant pattern and a flag pattern?

    Understand the basics of both the flag and pennant continuation patterns, their similarities and differences, and how each ... Read Answer >>
  5. What are the best indicators for evaluating technology stocks?

    Technology stocks are often some of the most discussed stocks on the news. How can investors spot the company that will roll ... Read Answer >>
  6. How should I analyze a company's financial statements?

    Discover how investors and analysts use a company’s financial statements to evaluate a company's financial health and investment ... Read Answer >>
Hot Definitions
  1. European Union - EU

    A group of European countries that participates in the world economy as one economic unit and operates under one official ...
  2. Sell-Off

    The rapid selling of securities, such as stocks, bonds and commodities. The increase in supply leads to a decline in the ...
  3. Brazil, Russia, India And China - BRIC

    An acronym for the economies of Brazil, Russia, India and China combined. It has been speculated that by 2050 these four ...
  4. Brexit

    The Brexit, an abbreviation of "British exit" that mirrors the term Grexit, refers to the possibility of Britain's withdrawal ...
  5. Underweight

    1. A situation where a portfolio does not hold a sufficient amount of a particular security when compared to the security's ...
  6. Russell 3000 Index

    A market capitalization weighted equity index maintained by the Russell Investment Group that seeks to be a benchmark of ...
Trading Center