No expert or brilliant doctor can predict the health of a business. Quickly identify the signs that a business is in trouble to protect your investment portfolio.
Investing in a business always requires careful consideration from each individual.
And of course, no investor would be uninterested in the kind of business they are investing in.
When you decide to invest, all the signs might indicate it's a very promising business, but after a few years, the situation can be quite different.
No one can be certain about the future. Quickly identify signs that a business is in trouble to protect your investment portfolio.
Here are a few signs that may indicate a business is on the verge of bankruptcy or experiencing serious financial difficulties.
1. Cash is decreasing frequently and continuously.
The amount of cash in hand needs to be sufficient to ensure the regular operation of the business and to respond to emergencies. You should be wary of companies whose cash reserves decrease quarter after quarter, whereas normally their cash turnover is very fast.
The balance sheet can be very helpful; consider the difference in cash compared to last year's report. Be aware that the company may have masked its cash situation by issuing new shares or taking on more debt.
2. The ability to pay interest on loans is questionable.
A company's income statement will tell us how it has been paying its interest. Can a company that consistently loses money and reports steadily declining sales still afford to pay its interest? Naturally, you'd want to see a brighter picture.
You want your business to generate more revenue, with enough cash at the end of the day to meet your creditors' obligations. However, in reality, companies are failing, or are on the verge of failing, so the scenario you envision is often difficult to achieve.
They rarely have the financial capacity to pay their bills. Financial indicators can help you better assess a company's ability to repay its debts.
The current ratio is a useful indicator. It is equal to total current assets divided by total current liabilities. It shows how many dollars of current assets are available to cover each dollar of current debt.
If this ratio is greater than 1, the business is considered to have a high ability to repay its debt obligations. Conversely, if this ratio is less than 1, it suggests that the business will not be able to repay its loans.
If you want to measure the liquidity of your current assets more effectively, you can use the quick ratio by dividing the total cash plus marketable securities plus accounts receivable by the total current liabilities.
Inventory and other illiquid current assets have been excluded from this calculation.
3. Changes to independent audit
All financial statements of publicly traded companies must be audited by an independent auditing firm. Companies rarely change their auditing firm, so a sudden change in the independent auditing firm could be a sign that something is amiss.
Typically, this sign indicates a discrepancy between book revenue and audited revenue, or a conflict among management members. And of course, this is not a good sign.
Another important consideration is the auditor's letter. As part of the reports sent to shareholders, auditors must write a letter stating that they believe the information in the balance sheet, cash flow statement, and income statement presented to shareholders is accurate and fair, and reflects the company's financial position correctly.
However, if auditors question whether the company is in a position to continue operating as a public company, or if auditors note that there are discrepancies that are generally considered the same in accounting practices, especially with regard to recorded revenue figures, these should be considered serious warning signs.
4. Dividend cuts
Companies that cut their dividend payout ratios to shareholders are not necessarily on the verge of bankruptcy.
However, it's important to acknowledge one thing: During difficult times, cutting dividends is always the first thing companies consider doing.
Therefore, you might view a reduction or restriction in the dividend payout ratio as a sign that the company is going through difficult times. Of course, other evidence should also be sought to support the decision of whether a company's dividend reduction should be considered a signal of "dark times" for the business.
To be more precise, when compared to other businesses in the same industry, if profits decline or fluctuate erratically while the company maintains a high dividend payout ratio, the free cash flow will inevitably be negative.
5. The departure of senior management personnel
Imagine you're on a ship sailing the open ocean and you discover it's sinking. Panicked and terrified, you'd try to escape, getting as far away from the ship as possible.
A company on the verge of bankruptcy is no different. Senior executives are always the ones who understand the company's situation better than anyone else. They have families, and they need jobs to support themselves and their loved ones.
Therefore, as soon as you realize things are going very badly, the company is in a disastrous decline, you will certainly see the departure of senior management personnel.
They will move to another company to seek a brighter future. This means that the remaining employees in lower positions will fill the vacant roles left by the departure of the higher-ranking executives.
6. Institutional investors and insiders sell a very large amount of the company's shares.
As intelligent and skilled investors, institutional investors and insiders who hold shares in a company will quickly sell them if they realize the company is showing signs of impending bankruptcy or is facing serious financial difficulties.
It's like fleeing when you realize a ship is sinking. Pay close attention to the selling activity of these smart investors, because it could be a significant sign.
However, during the normal operating period of the business, these smart investors can still sell their shares according to their plans. And in fact, this is quite normal.
It's important to pay attention to larger-than-usual transactions, especially those occurring just before, during, or immediately after unfavorable company information is released.
Selling top-performing assets/equipment/products: If you're going through a very difficult time, you might consider using your savings.
And when your savings run out, you might have to think about selling some assets. But you certainly wouldn't sell mementos, would you? The same goes for businesses.
Therefore, if you see a business selling its entire headquarters, or selling one of its most famous products, or selling off a valuable piece of equipment in order to raise cash, there is no doubt that bankruptcy is imminent.
7. Large salaries and benefits were cut.
Typically, before major problems begin, companies will try to cut benefits, pension plans, and other compensation and perks.
A drastic and sudden cost-cutting is a sign that problems within the business are becoming serious. Look for this in press releases or annual financial reports.
Hopefully, with these signs, you will quickly recognize the true situation of the business and your investment portfolio will remain safe.
EXPERTIS provides professional services.
For further information, please contact us Hotline – 0903 024 034
