3 red flags signal a troubled stock

Here's how to identify three of those telltale signs, which I call red flags, warning of future bad news. You can easily check for these red flags using the financial statements. You'll need a calculator, but the calculations are easy. Once you get the hang of it, you'll be able to do the analysis in less than five minutes. You'll find it well worth the effort.

Red flag 1: Deteriorating gross margins

I'll start with gross margins, which are most useful for detecting deteriorating competitive conditions. Gross margins measure the profit a company makes on each widget it sells before accounting for overhead, marketing, research and development cost, interest and taxes. Gross margins tell you a lot about a firm's competitive position. Rising gross margins tell you that a firm is either reducing production costs or raising prices. Whatever the reason, margins tend to move in trends and rising margins point to future positive earnings surprises.

Conversely, deteriorating margins say that either production costs are increasing and the firm can't raise prices proportionally, or that it is cutting prices in an attempt to maintain market share. Since either condition portends future earnings shortfalls, declining gross margins is a red flag.

Calculate gross margins by dividing gross operating profit by sales for the same period. To rule out seasonal variations, always compare the most-recent quarter's gross margin to the same quarter one year ago.

Red flag 2: Accounts receivables vs. sales
Corporations usually don't pay cash when they buy from another company. Instead, they have a predetermined time, say 90 days, to pay for the goods. The amounts owed to a company by its customers for goods received are termed "accounts receivables."

Usually, receivables track sales. For instance, if a company sells twice as much as it did the year before, you would expect its receivables to double. Sometimes sales grow faster than receivables, which signals that the firm is doing better at collecting its bills, which is good.

But beware when receivables increase faster than sales. That means customers are taking longer to pay their bills. Here are three reasons why that could happen:

• The company is slow in billing its customers.

• Customers don't have the cash to pay.

• The firm is giving its customers longer payment terms to encourage them to order products that they really don't need, a practice known as "channel stuffing."

While No. 1 is fixable, reasons No. 2 and No. 3 will likely result in sales and earnings shortfalls in the not-too-distant future.
To analyze receivables, compare the ratio of receivables (found on the quarterly balance sheet) to sales (income statement) for the most recent quarter to the same ratio for the year-ago quarter.

Red flag 3: Rising net income combined with a decline in operating cash flow
Cash flow measures the cash that moved in or out of a company's bank accounts during a reporting period. Since cash flow must be reconciled to actual bank balances, it is a more-reliable measure of a company's results than reported earnings, which are subject to a variety of arbitrary accounting decisions.

Operating cash flow measures the change in bank balances resulting from a firm's main business. When a firm calculates its net income, it deducts a variety of non-cash accounting entries such as depreciation and amortization.

Operating cash flow is mainly net income with those non-cash accounting entries added back in. So, generally, operating cash flow should exceed net income. But in fact, many firms find ways to report positive net income when they are actually losing money when you count the cash.

Recent academic research found that comparing reported net income to operating cash flow is a good way to spot future problems.

Specifically, the researchers found that the combination of rising net income and declining operating cash flow is a red flag pointing to future earnings shortfalls.

Doing the analysis doesn't even require a calculator, but interpreting a cash-flow statement is a little tricky. The quarterly statements show the cumulative year-to-date totals for each quarter instead of each quarter's individual figures. For instance, if a firm's fiscal year starts with January, its June quarter figures include the total of the March and June quarters. To get the June quarter's operating cash flow, you would have to subtract the March totals from the June totals.

However, there's no particular advantage to analyzing the quarters separately. So, I take the easy way and compare the most-recent quarter numbers to the year-ago figures, regardless of whether they represent single or multiple quarters. To do the analysis, simply compare the change in net income to the change in operating cash flow from the year-ago quarter to the most recent quarter.

Here are the numbers you would have found had you checked Jos. A. Bank's cash-flow statement after it reported its January 2006 quarter results (Since the company's fiscal year ends with its January quarter, the cash-flow statement figures for January actually represent the entire fiscal year).

Better safe than sorry. Nothing always works in the stock market and these three red flags are no exception. Sometimes cash flow drops because a company loads up on inventory for a new product introduction, or gross margins drop due to short-term conditions.

Nevertheless, successful investing is more about avoiding disastrous losses than it is about riding hot stocks. Paying attention to these red flags will help you do that.

source: deep wealth