Investing is a rewarding journey if done properly. To make an informed investment decision, it is essential to review a company's balance sheet. The financial statement offers a sneak peek into a company's financial health, including its assets, liabilities, capital invested, etc.
However, only some balance sheets tell the truth; some may harbour red flags that you should be able to spot. By spotting these red flags in the company balance sheet, you can avoid the significant losses you may have to bear otherwise.
In this blog, our experts from NIWS, one of the best trading institutes in Delhi, Jaipur and Indore, will guide you through the key warning signs in a balance sheet when analysing the statement and making an informed decision. Check out these red flags to ensure safe and profitable investments.
Let's discuss the most common red flags in company Balance sheets-
A consistent cash flow indicates healthy financial health, but irregular cash flow can indicate operational issues. So, if you spot any fluctuations or negative cash flow, consider them a red flag.
For example, suppose a company has consistent sales but a statement showing a major drop in cash flow from operations. In that case, either the company has high inventory levels or increased credit sales that are not being collected promptly.
When companies classify expenses inappropriately to improve the balance sheet, they present wrong information. This misinterpretation of expenses can be a mistake or intentional, but it is a red flag.
For example, if a tech company shows routine software updates as a capital expense instead of an operational expense, it is misinterpreting the costs.
Debt-to-income ratio (DTI) is all your monthly debt payments divided by your gross monthly income. When you spot a consistent increase in this ratio- it means the company heavily relies on borrowing, which can lead to financial instability.
For example, a manufacturing firm's debt-to-income ratio increases from 2:1 to 3:1 over two years. This clearly indicates that the firm is taking on more debt without a corresponding increase in income.
When revenue decreases year over year, this means the company may be struggling due to market competition, management inefficiencies, or product issues. This decrease should be consistent for you to count it as a red flag. Once you know the reason behind the decrease in revenue, you will be able to make an informed decision.
When a company sets aside some amount of money when it is performing well with the intention of boosting earnings when it is performing poorly, this is called cookie jar accounting. When someone does this, they are basically misleading the investors, which can be considered a red flag.
A higher account receivable means your customers are paying on time, and the company is good at collecting. However, when rising account receivables cannot be backed by rising revenue, the company needs help to collect payments from its customers, potentially leading to cash flow problems.
When a company owes more than it owns, it is in trouble. It is a sign that the company is struggling with financial distress and potential insolvency.
When a company makes less profit from its sales, its gross profit margin decreases. Increased production costs or lower sales prices can cause this.
When you pay close attention to these red flags, investors can better evaluate the company's financial condition. These red flags help you make an informed decision while investing and avoid the pitfalls you would have been in. Having an accurate picture of a company's financial health is crucial, as it is the deciding factor for any investor.
If you wish to learn how to scrutinise a company's balance sheet and gain a clear perspective on other factors you should consider while investing, you can opt for courses at NIWS. We have multiple course modules designed by industry experts to educate students about the stock market, wealth management, etc. Connect with us now!
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