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3 warning signs all investors must look out for

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In spite of how much we believe in them, it’s a fact that not every company we invest in will thrive or even survive. That’s why it’s so important for private investors to develop a habit of regularly reading announcements from businesses they own to check for any potential red flags. 

Here are just three things that should ring alarm bells.

1. Pessimistic tone

Regardless of how dire recent trading has been, one thing you can be fairly sure of is that a company will always be able to find a positive number or two to focus on. Usually, these will feature right at the top of reports in the hope that most readers won’t have the desire, time or energy to leaf through what can often be sizeable documents. As such, it can often makes sense to also look beyond these initial figures and focus on what message the company’s CEO or Chairman is conveying to the market through his/her statement.

Here, you’re looking out for anything remotely negative or just plain vague. References to “challenging market conditions“, “a lack of visibility” or anything being “below expectations” are usually signs of a less-than-rosy outlook. Of course, some of this could be the result of macroeconomic events that are beyond the company’s control. In such a situation, it may also be worth scrutinising the latest results from other businesses operating in the same market. If they are experiencing similar headwinds (and the long-term prospects for the industry remain positive), staying invested might be the best course of action. 

2. Over-complicated accounts

Another indication that all might not be well would be if a company’s accounts appear unnecessarily complicated.

To be sure, some businesses are — by their very nature — devilishly complex beasts. Those providing financial services are a good example. In most other cases however, it should be pretty easy to follow how a company makes its money. Either they’re selling more of what they produce and making more money from it or they’re not.

For this reason, any mention of obscure financial transactions, special “one-off” costs that somehow keep recurring, or a growing gap between net income and cash flow, could indicate a company’s finances aren’t quite as healthy as its board is implying.

Even if a company’s accounting practices are sound, the greater their complexity, the higher the likelihood that any earnings projections will need to be revised later down the line. With this in mind, the presence of multiple footnotes and caveats within a set of results can suggest that the numbers aren’t quite as useful as they first appear. 

3. A rise in receivables or inventory levels (or both)

While allowing customers to buy products or services on credit isn’t always bad for business (particularly if it represents only a relatively small proportion of revenue), the longer this continues, the greater the chances that some may default on their payments. If receivables are growing quicker than total sales, the company really needs to get its act together.

A rise in inventory levels may also be problematic and imply of a drop in sales. The longer products remain in the company’s possession, the greater the possibility that they might spoil or become obsolete.

In both situations, the old adage about time being money rings true.

Make no mistake

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Paul Summers has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.