What Is a Red Flag?

A red flag is a warning or indicator, suggesting that there is a potential problem or threat with a company's stock, financial statements, or news reports. Red flags may be any undesirable characteristic that stands out to an analyst or investor.

Red flags tend to vary. There are many different methods used to pick stocks and investments, and therefore, many different types of red flags. So a red flag for one investor may not be one for another.

A red flag for one investor may not be one for another.

How Red Flags Work

The term red flag is a metaphor. It is generally used as a warning or a cause for concern that there is a problem with a certain situation. In business, there may be red flags that warn investors and analysts about the financial future and/or health of a company or stock. Economic red flags often suggest problems looming for the economy.

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, analyst, or economist employs. This may include examining financial statements, economic indicators, or historical data.

Investors need to exercise due diligence when considering whether to make investments in a company or security. Financial statements provide a wealth of information about the health of an organization and can be used to identify potential red flags. However, identifying red flags is nearly impossible if the investor cannot properly read financial statements. Gaining a solid understanding of and being able to read financial statements helps ensure success when investing. 

Some common red flags that indicate trouble for companies include increasing debt-to-equity (D/E) ratios, consistently decreasing revenues, and fluctuating cash flows. Red flags can be found in the data and in the notes of a financial report. A pending class action lawsuit against the firm, which could compromise future profitability, is one red flag that is often found within the notes section of a financial statement.

Key Takeaways

  • A red flag is a warning or indicator, suggesting that there is a potential problem or threat with a company's stock, financial statements, or news reports.
  • A red flag for one investor may not be one for another.
  • The method used to detect problems with an investment opportunity depends on the research methodology an investor, analyst, or economist employs.

Problems With Financial Statements

Red flags may appear in the quarterly financial statements compiled by a publicly-traded company's chief financial officer (CFO), auditor, or accountant. These red flags may indicate some financial distress or underlying problem within the company.

Red flags may not be readily apparent on a financial statement, so it may take further research and analysis to identify them. Red flags usually appear consistently in reports for several consecutive quarters, but a good rule of thumb is to examine three years' worth of reports to make an informed investment decision. 

Corporate Red Flags

Investors can look at revenue trends to determine a company's growth potential. Several consecutive quarters of downward-trending revenue can spell doom for a company. 

When a company takes on more debt without adding value to the business, the debt-to-equity ratio could rise above 100%. High debt-to-equity ratios raise red flags for investors. The perception may be that the company is not performing well and is too risky an investment since more creditors finance operations than investors. 

Steady cash flows are indicative of a healthy and thriving company, while large fluctuations in cash flows could signal a company is experiencing trouble. For example, large amounts of cash on hand could mean that more accounts are being settled than work received. 

Rising accounts receivables and high inventories may mean a company is having trouble selling its products or services. If not remedied in a timely fashion, investors will question why the company is unable to sell its inventories and how this will affect profits. 

Economic Red Flags

Economists and investors are able to identify signals that the economy is in trouble or is heading toward a downturn. Stock market bubbles may be one indication. This was a precursor to the Great Depression of 1929, and led to the erosion of the savings of millions of people. Bubbles are generally characterized by a rapid increase in asset prices, and are deflated after massive sell-offs. This leads to a contraction.

Weaker retail sales may also be a red flag for a weakening economy. This indicator accounts for about two-thirds of the American economy, making it a very important consideration. Consumers begin to curb their spending, holding off on purchasing things like furniture, clothing, food, electronics, and appliances. This may be due to higher debt levels, a lack of change in income levels, and even job security. The weaker the retail sales, the weaker the economy becomes.