What is a Red Flag
A red flag is a warning or an indicator of a potential problem or threat, such as any undesirable characteristic that stands out to an analyst as it pertains to a company's stock, financial statements, or news reports. Because there are many different methods used to pick stocks and investments, there are many different types of red flag. Furthermore, a red flag for one investor might not be one for another.
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 (CFO), 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; 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. There are some common red flags that indicate trouble for companies: increasing debt-to-equity ratios, consistently decreasing revenues, and fluctuating cash flows.
Examples of 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. Many perceive 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. Contrastingly, large fluctuations in cash flows could signal that 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.
Exercising due diligence is important when considering whether to invest 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. Red flags can be found in the data and in the notes of a financial report. An example of a red flag contained within the notes section of a financial statement would be a pending class action lawsuit against the firm, which could compromise future profitability.