5 Financial indicators that tell a stock is in trouble

  • Matus

A lot has been written about how to find great stocks or identify undervalued companies. But little attention is given to how to monitor your holdings and when to sell a great business. How do you know a business is deteriorating? By the time it shows in a company’s net income, it might already be too late. There are a few signs that can be spotted early, which tell you a company is having problems.

Declining revenue growth

Growing revenues are a sign of business strength and indication of customer demand. When a company’s revenues this year are above the previous year, it means the company has either sold more of its products or services, made an acquisition or increased prices.

If a company has been growing briskly and suddenly reports a quarter or two of slowing growth, it might be a sign of trouble. The growth rate is usually very irregular and can go from 30% to 22% and then back to 35%. But if a growth rate declines by at least 50%, that is from 30% to 15% in one or two quarters, it might be time to consider taking some profit on the stock.

Decreasing gross margins

The absolute level of gross margins is important, that is the higher the better. The more money a company keeps from its revenue, the more is left for research and development, marketing and other costs. But the trend is important as well. It pays to be invested in businesses that increase their gross margins over time or at least maintain them at a certain level. For example, if a company has revenues of $100 million, gross margin of 50% and operating expenses of $40 million, its operating income will be $10 million. A mere 1% increase in gross margin to 51% produces $11 million in operating income, or a 10% increase.

When gross margins decline, it might mean increased competition and thus discounting of a company’s products or services, rising raw material costs or other problems. In other words, declining gross margins are never a good sign.

Rising debt levels

Indebtedness in a business can be measured in many ways, usually through its debt/equity ratio, net debt/EBITDA ratio or interest coverage. Debt to equity measures interest bearing liabilities (bonds, bank debt) against the equity capital that was inserted into the company. So if a business has $500 million in debt (both short-term and long-term) and $1 billion in equity, its debt/equity ratio is simply 0.5. Now the higher it is, the more dangerous the situation becomes, as the debt is supported by less and less equity capital. Debt/equity below 1.5 is considered ok, but once it starts rising above it, be careful.

The net debt/EBITDA ratio measures total interest bearing debt minus cash and short-term investments divided by last 12 month EBITDA. In essence, it tells us how many years it would take to pay down the debt if the company used its entire EBITDA for it. A net debt/EBITDA ratio of 2-3 is considered normal, above 6 is dangerous.

There are 2 primary reasons why companies go bankrupt, and this either the demand from customers evaporates or the business just used too much debt. By keeping a close look on debt levels, an investor can avoid the second scenario. It’s not coincidence that the best investors like Warren Buffett, Peter Lynch or John Templeton preferred companies with low debt.

Insider selling

There are many reasons why a single insider might sell stock in a company. He or she might want to cash a portion of holdings and buy a house, or it might be due to a family or health problem.  Isolated selling by an insider is not a problem and happens very frequently. A problem arises, when several insiders sell at once and the sales are a large percentage of their holdings.

An insider’s ownership can be easily accessed in a proxy filing (DEF14A), you can then compare the size of the sale to the total and see if it’s significant or not.

Operating cash flow vs net income divergence

Cash flow is the lifeblood of a business. A company can have positive earnings but still run out of cash and get into trouble. That’s why it’s important to monitor the operating cash flow  to net income ratio. When a company’s operating cash flow is $150 million and net income is $100 million, the ratio is 1.5 and it indicates a healthy business. If the ratio starts slipping below one, it means the company might be inflating its earnings. The next step is to examine working capital and determine if it’s only a one off thing or i fit might continue. If the ratio is below 1 for several years, the company is likely an earnings manipulator and might be burning cash and heading towards bankruptcy as well.

These are just a few indicators that help investors determine whether to continue holding a stock or sell it. If any one of these indicators starts to flash a warning signal be careful, if more of them deteriorate it might be time to trim your stock position.