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.

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