Few people seem to spot the early signs of a company in distress. Largely investors are occasionally caught off-guard by a stock that rapidly falls in price. While it’s not always possible to predict a stock price tumble, there are several warning signs that can help to alert the investor.
When a company’s cash payments exceed its cash receipts, the company’s cash flow is negative. If this occurs over a sustained period, it’s a sign that the company’s cash in the bank may be getting dangerously low.
If a company’s earnings are falling, the stock will eventually fall, too.
Interest repayments place pressure on cash flow, and this pressure is likely to be exacerbated for distressed companies. Because they have a higher risk of default, struggling companies must pay a higher interest rate to borrow money. As a result, debt tends to shrink their returns. The total debt-to-equity (D/E) ratio is a useful measure of bankruptcy risk. Companies with D/E ratios of more than 1 deserve a closer look.
Combing the interest coverage ratio with the net debt to equity ratio provides a powerful test. The ratio simply divides a company’s earnings before interest and tax (EBIT) by the net interest expense associated with carrying debt. A ratio of 1.0 or lower indicates a business is highly burdened by debt expense and is likely to be suffering, and vice versa.
Investors should take profit warnings seriously. A profit warning is often followed by a gradual share price decline.
Companies are required to report, by way of company announcement, purchases and sales of shares by substantial shareholders and company directors. Executives and directors have the most up-to-date information on their company’s prospects, so heavy selling by one or both groups can be a sign of trouble ahead.
The sudden departure of key executives (or directors), and/or auditors can also signal bad news. While these resignations may be completely innocent, they demand closer inspection. Warning bells are the loudest when long-term directors with a track record of good management leave.
The signs are there if you know where to look. Effectively evaluating the warning signs can prevent a catastrophic loss in the stock market. Spend a few minutes each week examining your stocks, and the market, for any signs that the price could take a significant tumble.