As mentioned, in this week’s article, I will be moving away from the basics and get into something deeper.
Link for the earlier post: https://www.investwhizz.com/2018/07/29/learning-series-profit-from-red-flags-3/
Overview of How Red flag
Can impact you
The definition of Financial Red Flag is anything that is abnormal in the Financial statements that often provide us early signals of the financial health of the company. Red flag can be on a stand-alone basis or a combination of a few.
Analyzing a company is like an “Art”. You can have a close estimate of the company’s direction but no one is able to be 100% sure of what it is going to become.
Being able to identify companies’ Red Flag allows investors to be aware of the risks and hence creating an edge for them to make better decisions.
Before going further, we would like to share with you real life case studies of people whom have invested in stocks without going through the Red flags.
Real Life Case Study
Jason did not look at the company’s financial health before investing. As a result, he had suffered close to 90% loss within 1month.
All thanks to “Stock Tips” given by his friend.. How many of you experienced this before? Say “I”
Now that you know how Red Flags have impacted others, we will zoom into the Top 10 Red Flags in the next chapter.
Go through the earlier post and ensure you fully understand
- Balance Sheet
- Income statement
- Cash flow statement
Red Flag #1
Revenue vs Receivables
In the below scenario, we are seeing company increasing Revenue from 12 Mil to 24 Mil (100% increase). However Receivables have increased from 1 Mil to 13 Mil (1,200% increase)
|Revenue||24 Mil||12 Mil|
|% increase in Revenue||100%|
|Receivables||13 Mil||1 Mil|
|% increase in Receivables||1,200%|
Red Flag: % Increase in Receivables more than % Increase in Revenue. We would question the company’s Revenue & quality of Receivables.
How can this happen:
- Company is very aggressive in obtaining business from customers by offering them extended credit terms (e.g Buy first but pay later)
- Existing customer are not making payment on time
- Company did not perform sufficient background check of customer before granting credit terms
- Fictitious order book has been created.
In this scenario, the company is running a very high risk as the 12Mil increase in Revenue is not paid by its customer. In the event where the customer defaults on payment, the company would be having a high risk of writing off losses.
In extreme cases, we have seen companies going to the extent of creating fake sales to boost their Revenue.
We would look at the break up of Receivable days in the annual report (if available) to assess the risk. Companies would normally disclose receivable days in the following category:
- 0 days – 90 days (Healthy)
- 90 days – 180 days (to monitor closely)
- More than 180 days (Unhealthy)
If the receivable days are > 180 days, we would generally write them off before valuing the company.
We would also look at the historical record of the company writing off bad debts as well as compare the average receivable days with the industry peers.
|Average Receivable days =||Total Receivable||X 365|
Note: Always remember to take a closer look at the quality of Revenue/Profit!
(P.s. I would be motivated to share more once the number of “like” is reached :). Do share the post if you think it can benefit people around you!
To make this more interactive, do post in the comment on what do you think the next 9 red flags could be!
Targeted likes: 200!