Red Flags

Red flags are either a flag used for signaling or, as a metaphor, a sign of some particular problem requiring attention.

from the desk of The Web Lender CEO, David Fisher.

Investing

Red flags are warnings or indicators of potential problems or threats, such as any undesirable characteristic that stands out to an analyst as it pertains to a company’s stock, financial statements, or news reports. Because there are many different methods used to pick stocks and investments, there are many different types of red flag. Furthermore, a red flag for one investor might not be one for another.

Financial Statements

Regarding publicly traded companies, red flags may appear in quarterly financial statements compiled by a company’s chief financial officer (CFO), auditor, or accountant. These red flags may indicate some financial distress or underlying problem within the company. Unfortunately, red flags may not be readily apparent on a financial statement; it may take further research and analysis to identify them. Red flags usually appear consistently in reports for several consecutive quarters, but a good rule of thumb is to examine three years’ worth of reports to make an informed investment decision. There are some common red flags that indicate trouble for companies: increasing debt-to-equity ratios, consistently decreasing revenues, and fluctuating cash flows.

Investors can look at revenue trends to determine a company’s growth potential. Several consecutive quarters of downward-trending revenue can spell doom for a company.

When a company takes on more debt without adding value to the business, the debt-to-equity ratio could rise above 100%. High debt-to-equity ratios raise red flags for investors. Many perceive that the company is not performing well and is too risky an investment since more creditors finance operations than investors.

Steady cash flows are indicative of a healthy and thriving company. Contrastingly, large fluctuations in cash flows could signal that a company is experiencing trouble. For example, large amounts of cash on hand could mean that more accounts are being settled than work received.

Rising accounts receivables and high inventories may mean a company is having trouble selling its products or services. If not remedied in a timely fashion, investors will question why the company is unable to sell its inventories and how this will affect profits.

Due Diligence

Exercising due diligence is important when considering whether to invest in a company or security. Financial statements provide a wealth of information about the health of an organization and can be used to identify potential red flags. However, identifying red flags is nearly impossible if the investor cannot properly read financial statements. Gaining a solid understanding of and being able to read financial statements helps ensure success when investing. Red flags can be found in the data and in the notes of a financial report. An example of a red flag contained within the notes section of a financial statement would be a pending class action lawsuit against the firm, which could compromise future profitability.

Funding

Clients seeking business funding are themselves red flags from the moment they submit a funding application, since all funding applications are approved based on the honesty of the client and the facts he / she presents. Due diligence today on all business funding applications is conducted as 80% on the client and 20% on the business. Then there are the questions clients ask and the comments they make. Here are some of the most common:

– When will my application be funded? (indicates urgency, an emotion which funders / investors don’t like);
– Before I submit an application I want to know the terms of the loan. (indicates ignorance of the funding processes);
– If you are successful in helping me acquire funding I’ll pay you a commission after I receive the money. (indicates a lack of faith in the business being funded);
– I’ve been looking for funding for this business for 5 years. (indicates this business may not be fundable or the client is a shopper).

Clients seeking business funding need to understand that lenders / investors are not sitting in an office behind a big desk waiting for their telephones to ring and they don’t have closets full of cash waiting to be handed out. Respect it has been said is something you have earn. Successfully acquiring business finance is no different.

 


 

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red flags