Chapter 23
Ten Signs That a Company’s in Trouble
In This Chapter
Pondering money problems
Finding reporting foibles
Identifying inventory unease
If you don’t recognise traffic signs, driving is going to be pretty hairy. By the same token, if you don’t recognise a company’s danger signs by reading the financial reports, your investment decisions may not be the best ones.
Many companies put out glossy financial reports with the most graphically pleasing sections providing only the news about the company that its managers want you to read. Don’t be fooled. Take the time to read the pages in smaller print and the ones without the fancy graphics, because these pages are where you find the most important financial news about the company. The following are key signs of trouble that you may find within these pages.
Lower Liquidity
Liquidity is the ability of a company to quickly convert assets to cash so it can pay its bills and meet other debt obligations, such as a mortgage payment on a bill or a payment due to bond investors. The most liquid asset a company holds is its cash in a current or savings account. Other good sources are cash equivalents, which include holdings that a company can quickly convert to cash, such as marketable securities, certificates of deposits, or other types of investments that can sell quickly and be turned into cash.
Other assets take longer to turn into cash, but they can be more liquid than long-term assets such as a building or equipment. Take, for instance, trade receivables. Trade receivables can often be liquid holdings for a company as long as its customers are paying their bills on time. If customers are paying late, the company will find that its trade receivables are ‘less liquid’, meaning that it takes longer for the company to collect that cash. We show you how to test a company’s trade receivables management in Chapter 16.
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Low Cash Flow
If you don’t have cash, you can’t pay your bills. The same is true for companies. You need to know how well a company manages its cash, and you can’t do that just by looking at the balance sheet and income statement. Neither of these statements reports what’s actually happening with cash.
Disappearing Profit Margins
Everyone wants to know how much money a company makes – in other words, its profits. If you find a company’s profit dropping year to year, that’s a clear sign of trouble.
Companies must report their profit results for the current year, in addition to the previous year, on their income statements, one of the three key financial statements that are part of the financial reports. (Refer to Chapter 7 for more information about income statements.) When investigating a company’s viability, looking at the past five years or more – if you can get the data – is a good idea. Luckily, finding a company’s historical profit data is easy. Most companies post some previous years reports on their Web sites.
Revenue Game-Playing
A day rarely goes by when you don’t see a story about company bigwigs who’ve played with their company’s revenue results. Although the number of companies being exposed for revenue problems has certainly fallen since the height of the scandals set off by the fall of Enron in 2001, a steady stream of reporting about the games that companies play with their revenue continues.
Problems can include managing earnings so that results look better than they are and actually creating a fictional story about earnings. We talk more about how companies play games with their revenue numbers in Chapter 21.
The Financial Reporting Review Panel (FRRP) performs some proactive monitoring of company financial statements. They announce each year the business sectors that they will examine in the coming year. In addition, they respond to complaints or tip-offs. If the FRRP begins an investigation, you are unlikely to know about it until the FRRP, or the company, issue a press release.
The initial stages of an investigation usually involve private enquiries between the FRRP and the company. The issues concerning the FRRP may well be resolved without any publicity. Alternatively, at the end of an investigation, having reached agreement with the company concerned, the FRRP issue a press release giving an outline of the problem and the agreed solution. Often the agreed solution is to use a different approach to measurement or disclosure in the following year’s financial statements. Only rarely has the FRRP insisted that a company reissues a previous set of accounts.
Too Much Debt
Borrowing too much money to continue operations or to finance new activities can be a major red flag that indicates future problems for a company, especially if interest rates start rising. Debt can overburden a company and make it hard for a company to meet its obligations, eventually landing the company in bankruptcy.
You can test a company’s debt situation by using the ratios in Chapter 12. Compare a company’s debt ratios with those of others in the same industry to judge whether or not the company is in worse shape than its competitors. These ratios are calculated based on numbers presented in the balance sheet and income statement.
Unrealistic Values for Assets and Liabilities
Some companies can make themselves look financially healthier by overvaluing their assets or undervaluing their liabilities:
Overvalued assets can make a company appear as if its holdings are worth more than they are. For instance, if customers aren’t paying their bills, but the trade-receivables item isn’t properly adjusted to show the likely bad debt, the trade and other-receivables item will be higher than it should be.
Undervalued liabilities can make a company look as though it owes less than it actually does. An instance of this would be when debts are moved off the balance sheet to another subsidiary to hide the debt. Concealing debts in this way is just one of the things Enron, and other scandal-ridden companies, did to hide their problems.
If a company has hidden its problems well to offset the overvaluing of assets or the undervaluing of debt, equity is probably overstated as well.
A Change in Accounting Methods
Accounting rules are clearly set in the Generally Accepted Accounting Principles (GAAP) developed by the International Accounting Standards Board (IASB). You can find details about the GAAP at the IASB’s Web site (www.iasb.org).
Sometimes a company can file a report that’s perfectly acceptable by GAAP standards, but it may hide a potential problem by changing its accounting methods. For example, all companies must account for their inventory by using one of four possible methods. Changing from one method to another can have a great impact on the bottom line. To find out whether this kind of change has occurred, read the fine print in the financial notes.
We talk more about accounting methods in Chapter 4 and delve even deeper into inventory-control methods in Chapter 15.
Questionable Mergers and Acquisitions
Mergers and acquisitions can be both good news and bad news. Usually, you won’t know whether a merger or acquisition will actually be good for a company’s bottom line until years later. So be careful about buying into the fray when you see stories about the possibility of a merger or acquisition. If you don’t already own shares, stay away until the dust settles and you get a clear view of how the merger or acquisition impacts the companies involved. If you do own shares, closely follow all the reports by the financial press and the financial analysts. You are, as a shareholder, able to vote for or against the merger or acquisition if it involves the exchange of shares.
You can get to know the issues by reading what the company sends out when it seeks your vote. Follow the stories in the financial press. Read reports from analysts about the merger or acquisition.
For example, just ask Time Warner workers what they think about their company’s merger with AOL; I’m sure you’ll hear many words of disgust, most not printable. Many of these employees held large chunks of shares in their retirement portfolios, which have lost most of their value. Time Warner shares dropped from a market value of $52.56 per share in January 2001, when the merger was approved by the US government, to $15.11 per share in September 2003, when the Time Warner board decided to drop AOL from its name, acknowledging the failure of the merger that was valued at $112 billion when it happened in 2000.
You don’t see much about mergers and acquisitions in the three key financial statements – income statement, balance sheet, and statement of cash flows; they rarely take up more than a line item. The key place to find out about the impact of mergers and acquisitions is in the notes to the financial statements, which we talk more about in Chapter 9.
Slow Inventory Turnover
One way to see whether a company is slowing down is to look at its inventory turnover (how quickly the inventory the company holds is sold). As a product’s lifespan nears its end, moving that product off the shelf tends to be harder and harder.
When you see a company’s inventory turnover slowing down, it may indicate a long-term or short-term problem. Economic conditions, such as a recession – which isn’t company specific – may be the cause of a short-term problem. A long-term problem may be a product line that isn’t kept up to date, so customers are looking to other companies or products to meet their needs. We show you how to pick up on inventory-turnover problems in Chapter 15 by using numbers from the income statement and the balance sheet.
Slow-Paying Customers
Companies report their sales when the initial transaction occurs, even if the customer hasn’t yet paid cash for the product. When a customer pays with a credit card issued by a bank or other financial institution, the company considers it cash. Only credit issued to the customer directly by the company selling the product is not reported as cash received. The reason is that the customer won’t have to pay cash until the company that issued the credit bills him. For example, if you have an account at Staples that you charge your office supplies on, Staples won’t get cash for those supplies until you pay your monthly statement. If, instead, you bought those same supplies using a Visa or MasterCard, the credit-card company would deposit cash into Staples’ account and then work to collect the cash from you.
Companies track non-cash sales to customers whom they have given credit to directly in an account called trade receivables, and customers are billed for payments.
But not all customers pay their bills on time. If you see a company’s trade receivables numbers continuing to rise, it may be a sign that customers are slowing down their payments, and eventually, the company may face a cash-flow problem. Go to Chapter 16 to find out how to detect trade-receivables problems.