Red Flags to Watch For

Red Flags: Warning Signs in Company Financials

Fundamental analysis is not just about finding good companies. It is equally important to identify warning signs that a company may be heading for trouble. Spotting red flags early can save you from significant losses.

Revenue Red Flags

• Declining revenue for 2 or more consecutive years — This could indicate a shrinking market, loss of competitive advantage, or poor management. Investigate whether the decline is industry-wide or company-specific.
• Revenue growing but profits shrinking — The company may be cutting prices to maintain sales volume, or costs are spiralling out of control. Margins are being squeezed.
• Heavy dependence on one customer or product — If a large portion of revenue comes from a single source, the company is vulnerable if that relationship ends.

Balance Sheet Red Flags

• Rapidly rising debt — If borrowings are increasing much faster than revenue and profits, the company may be overleveraging. Check the debt-to-equity ratio over time.
• Negative or shrinking equity — If liabilities exceed assets, the company is technically insolvent. This is a critical warning sign.
• Growing receivables — If accounts receivable are rising faster than revenue, the company may be struggling to collect payments from customers.

Cash Flow Red Flags

• Profits but negative operating cash flow — If the company reports profits but cash from operations is negative, the reported profits may not be real. This is one of the most important red flags.
• Constant need for external financing — If the company regularly issues new shares or takes on new debt, the core business may not be self-sustaining.

Governance Red Flags

• Qualified audit opinion — The external auditor has raised concerns about the financial statements. Take this very seriously.
• Frequent change of auditors — Companies that switch auditors often may be looking for one that will overlook issues.
• Related-party transactions — Large transactions with companies owned by directors or their families deserve scrutiny.
• Delayed financial reporting — Companies that are late publishing results may be trying to hide bad news.

One red flag may have an innocent explanation. Multiple red flags appearing together should make you very cautious about investing.