Red flags to look out for when investing in a company? - Seedly

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Asked by Anonymous

Asked on 18 Apr 2019

Red flags to look out for when investing in a company?

Are there any prominent indicators that I should be aware of when it comes to investing?

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Richard Woon Tian Jun
Richard Woon Tian Jun
Level 6. Master
Updated on 07 Jun 2019

Below 1 TIE Ratio for consecutive years is a definite red flag for me. This means they can't even produce enough earnings to cover the interest payments owed by them to their creditors. If their assets aren't able to pay off their debtors, equity holders will get absolutely nothing (hyflux). A big big lesson to learn there is that we need to be extremely clear that private companies aren't going to be bailed out by the government because of poor management, and unrated bonds must have even higher scrutiny involved regarding financial statements to see that they can meet their obligations.

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Manferd Hoe
Manferd Hoe

19 Apr 2019

Thanks! learn a new ratio today!
Sandra Teo
Sandra Teo
Level 6. Master
Answered on 19 Apr 2019

Hi there!

Some red flags I would look out for include 1) Turnover of CFO, 2) high profits, low cashflow, 3) frequent, non-recurring gains (or losses)

  1. Turnover of CFO

The turnover rate of CFO could give insights into how the finances of the company is panning out. The CFO has first-hand information about where the revenues are generated, where the outflows are, what the ROI is and how the resources are allocated. A CFO quiting could potentially mean the company is headed for disaster or that the company is doing something behind the scene that requires some scrutiny.

  1. High profits, low cash flow

A profitable company with insufficient cashflow can put the company at risk of bankruptcy. For example, Toys "R" Us initially was a profitable business however year or year it had an increasing cash outflow required to service its interest payments. Due to the huge interest payment and decreasing sales, the firm was forced into bankruptcy.

  1. Frequent, non-recurring gains

Non-recurring gains and losses should not occur frequently because they do not relate to normal business operations. If there is a trend of non-recurring gains and losses, it could be that the company is finding ways to write off or write down transactions to make the business look a certain way.

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Yeo Enk Loui
Yeo Enk Loui
Level 6. Master
Answered on 21 Apr 2019

Hi there!

One ratio that I might want to take a closer look at is the Debt Service Coverage Ratio, which is a measurement of the cash flow available to pay current debt obligations.

While TIE and DSCR essentially measures the same thing, DSCR is slightly more comprehensive, assessing the ability of a company to meet its minimum principal on top of interest payments.

Lenders will routinely assess a borrower's DSCR before making a loan. A DSCR of less than 1 means that the borrower will be unable to cover or pay current debt obligations without drawing on outside sources – without, in essence, borrowing more.

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Wilson Nid A Break
Wilson Nid A Break
Level 4. Prodigy
Answered on 18 Apr 2019

Beside the usual red flags, there are other things to take note as below:

  1. The inability of the share price to rebound over time along with its peers after a market correction like recent times, an indication that its fundamentals is subjected to scrutiny & suspect by market. Even though it might seem like a value buy at first instance, there are times could turn out to be a value trap. Etc see Breadtalk's share price, it had been in a stagnant mode since the 2018 market collapse, most stocks had send a rebound for the past 2-3 months meantime.
  1. The reluctantness of management to reward shareholders over time, even though company is generating freecash flow or received gains via divestment & kept hoarding the cashpile with no intention to either expand the biz or do R&D etc
  1. Mgmt incentives not aligned with shareholders' interest such as mgmt's lion share of their compensation derived from asset acqusition rather than improving the bottomline

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Some that I look out for:

  1. Declining profits

  2. Low profit margins or falling margins

  3. Very high debt

  4. Dividend payout ratio too high, paying out more than sustainable

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