The Basics of Spotting Financial Red Flags

Before you take a job, you want to spend as much time checking out your prospective employer as they’ve spent checking out you. Among the most important things to look at is the company’s financial health. After all, if business is falling its need for staff may not be far behind. But even if you’ve been at a company for years, it’s good to know how you can spot business problems before they become a crisis.

Red Flag WarningSo what are the danger signs? “The things that were relevant during the dot.com era are still relevant today,” says Leland Hevner, president of the National Association of Online Investors.

One of the first places to look for an overview of the company’s performance is in its annual report, or 10-K document, which can be found in either the investors’ section of the company’s website or at the Securities and Exchange Commission’ site. Punch in the company’s name under the “Filings” menu tab, then click on “Company Filings Search.” Once you’ve got the document, find the “management discussion” either by searching or through the report’s table of contents. “Sometimes they talk about things that only Wall Street analysts understand, but if there is anything wrong with the company, they should bring it up here,” Hevner says.

Hevner advises job seekers to also review the company’s key metrics against overall industry performance. A good starting point is money.msn.com, where you can enter the ticker symbol of any publicly traded company. As an example, let’s use Apple’s ticker symbol (AAPL).

In the resulting report, click on “Key Ratios” under “Fundamentals” in the left column.  On the next screen, click “Financial Condition” in the menu below the stock price. Here are two important categories you’ll see on the table that appears:

  • Debt/Equity Ratio. This will tell you if the company has a high debt ratio compared to the industry norm. “If a company’s mountain of debt is too high to climb, the company may never be profitable,” Hevner says. “You want to find a company that is at the industry level or lower.” If a company has a 0.25 ratio, that is a “pink flag,” Hevner says. A 0.5 ratio is a red flag.
  • Interest Coverage. Each company usually has to pay interest on corporate bonds, loans, dividends, etc. This ratio tells you how well its revenue is covering those payments. “You don’t want a company defaulting on their bond payments because the bondholders, in extreme cases, will take control of the company through the court,” Hevner explains. “You want a company’s interest coverage higher than the industry.”

Then, go back up to the menu and under the stock price and click on “MGMT Efficiency.” On the resulting table, find:

  • Income/Employee. This metric shows the degree that management is able to efficiently use its workforce based on operating income per employee. While in tech the norm is $67,000 per employee, Apple cranks out over $400,000 in income per employee. “If I am expected to generate half a million in income on average, I may ask for a little more in salary to take the job,” says Hevner. The bigger the number, the better.

Another place to look for financial information is a company’s quarterly earnings report, or “10-Q.” Here again, you can find the report on either the company’s or SEC’s website.

Check out the “accounts receivables” line in the balance sheet section. If the number doubles from one quarter to the next, then there could be trouble. “If you get in the weeds, you need to find big animals. A doubling or tripling of accounts receivables is like an elephant in the room,” Hevner says. What it means is that the company may have more customers who are slow at paying, rather than ponying up upon receipt of the service or product.

A second document in the 10-Q is the “cash flow statement.” Within this, go to the line that says “cash and cash equivalents,” which is often at the very end. (You can find a cash flow statement in the annual report, as well.) Ideally, you should pull three years’ worth of annual earnings statements to map out trends over time. “If you have three years in a row where the number is declining and in the red, you should be concerned,” Hevner says.

Bear in mind that numbers need context to be meaningful. For example: While growing accounts receivable may indicate a problem with collections, it may also result from an increase in business. You have to look at revenue numbers to see whether that might be the case. If revenue and accounts receivables are both up, that’s good. But if revenues are flat and receivables are rising, that could be a sign of trouble.

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