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.
#1 NEGATIVE CASH FLOWS
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.
#2 HIGH DEBT TO EQUITY RATIO
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.
#3 INTEREST COVERAGE RATIO
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.
#4 PROFIT WARNINGS
Investors should take profit warnings seriously. A profit warning is often followed by a gradual share price decline.
#5 INSIDER TRADING
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.