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Welcome to Wealth Wednesday! These Red Flags will help you become a better investor.
Here’s What You Missed Last Week:
Dear Friend,
Most investors love a good story. The promise of innovation, a visionary founder, or an eye-popping growth trajectory.
But stories can be misleading. Beneath the buzzwords and earnings calls lies a company’s true health on its balance sheet.
Accounting is the language of investing.
If you don’t understand it, you’re operating blind. And while every balance sheet tells a story, not all stories end well.
A balance sheet shows what a company owns, owes, and what’s left for shareholders. It’s one of three essential financial statements, alongside the income statement and the cash flow statement.
You might be asking, Matt Allen, where do I even find a company’s balance sheet? Great question. For publicly traded companies, it’s easy check their quarterly (10-Q) or annual (10-K) filings on the investor relations section of their website. I personally use Yahoo Finance or FinChat.
When I started investing, I didn’t pay enough attention to balance sheets.
I focused on stories and growth, which led to painful lessons. Let me save you from that experience.
Here are 7 critical red flags to watch for on a balance sheet and why ignoring them could cost you big.
1. High Debt Levels
Debt is a double-edged sword. Used wisely, it fuels growth. But excessive debt can quickly turn into a noose, especially during economic downturns or when interest rates rise.
Why it’s a red flag:
A company with high debt levels is like a swimmer with ankle weights—progress is possible, but one misstep could pull them under. Servicing debt becomes a priority over investing in the business or returning value to shareholders.
Example: J.C. Penney
J.C. Penney borrowed heavily to remodel stores and boost its appeal, but declining sales and mounting interest payments crushed those efforts. The pandemic was the tipping point, and bankruptcy soon followed.
What to look for:
Debt-to-equity ratio above 2:1: This indicates the company is heavily financed through debt. Compare this metric to industry norms; for example, utilities often have higher ratios because of stable cash flows.
Interest coverage ratio below 3x: This ratio, calculated as EBIT/Interest Expense, shows how easily a company can cover its interest payments. Anything below 3 signals trouble.
Example: A company with EBIT of $1 million and $400,000 in interest expense has a ratio of 2.5, indicating it struggles to manage debt payments.
Debt service coverage ratio (DSCR): This metric compares operating income to total debt payments. If it’s less than 1, the company can’t generate enough income to meet its debt obligations.
Example: Many real estate firms failed during the 2008 crisis because their DSCRs dropped below 1 as rental income plummeted while debt obligations stayed the same.
2. Negative Equity
Negative equity isn’t just a red flag—it’s an air raid siren. It means the company’s assets are worth less than its liabilities, leaving shareholders with nothing in a worst-case scenario.
Why it’s a red flag:
Negative equity leaves no buffer for operational missteps or economic downturns. Companies with this issue often rely on borrowing or issuing new equity just to stay afloat, diluting shareholders in the process.
Example: Hertz
Hertz had been skating on thin ice long before COVID-19 disrupted the travel industry. When travel demand dried up, its massive debt burden became a death sentence. Negative equity left it unable to secure funding or restructure its obligations.
What to look for:
Shareholder equity trends: Look at the company’s retained earnings over time. Declining retained earnings suggest profits are being eroded, potentially turning equity negative.
Example: A company paying out dividends despite declining earnings could be masking deeper financial struggles.
Debt-to-asset ratio above 1: This means liabilities exceed assets. Industries like airlines and energy often operate with high leverage, but even they rarely exceed this threshold for long without consequences.
Example: During the 2020 oil crash, several energy companies with debt-to-asset ratios above 1 filed for bankruptcy as oil prices fell below breakeven costs.
3. Declining Asset Quality
When the quality of a company’s assets deteriorates, it signals inefficiency, poor management, or failure to adapt to market changes.
Why it’s a red flag:
Assets losing value reduce the company’s ability to generate revenue. If inventory becomes obsolete or accounts receivable remain unpaid, the balance sheet starts to crumble.
Example: Kodak
Kodak’s assets were tied to film-based photography, which quickly became irrelevant as digital technology took over. This inability to adapt left the company with declining asset quality and eventual bankruptcy.
What to look for:
Frequent write-downs: If a company is regularly adjusting asset values downward, it indicates the assets are worth less than expected.
Example: A retailer stuck with unsold seasonal inventory might write it down, impacting both the income statement and balance sheet.
Inventory turnover ratio: This measures how quickly a company sells and replaces its inventory. Low turnover suggests inefficiency or weak demand.
Example: A healthy ratio in retail is around 8. If it drops to 4, the company is sitting on inventory for twice as long as before.
Allowance for doubtful accounts: Check if the company is setting aside more reserves for uncollectible receivables. A sudden spike suggests trouble with credit risk.
Example: Car manufacturers often see this rise during economic downturns when dealerships delay payments.
4. Increasing Accounts Receivable
Accounts receivable should grow in line with revenue. If they outpace revenue growth, it could mean customers aren’t paying on time—or revenue recognition is aggressive.
Why it’s a red flag:
Rising accounts receivable drains cash flow and raises questions about the quality of reported earnings. In extreme cases, it can indicate fraud or manipulation.
Example: Carillion
Carillion aggressively booked unpaid invoices as revenue, creating an illusion of growth. But when clients failed to pay, the company collapsed under mounting debt.
What to look for:
Days sales outstanding (DSO): This metric shows how many days it takes to collect payment. A rising DSO suggests delays in collections.
Example: A DSO of 60 days in an industry where 30 is the norm indicates payment issues.
Receivables-to-revenue ratio: If this ratio climbs consistently, investigate why.
Example: A company might book revenue from a large project before receiving payment, inflating earnings.
Allowance for doubtful accounts: An increase here signals management knows collections are a problem.
Example: Tech companies during the dot-com bubble often boosted allowances as start-ups struggled to pay for services.
5. High Inventory Levels
Inventory represents tied-up capital. Too much of it risks obsolescence, especially in fast-moving industries like technology or fashion.
Why it’s a red flag:
Excess inventory hurts cash flow and signals poor demand forecasting. In extreme cases, it forces write-downs that impact both the balance sheet and income statement.
Example: Toys “R” Us
Overloaded warehouses drained cash and hurt operational flexibility. As sales declined, the inventory became a liability rather than an asset.
What to look for:
Inventory-to-sales ratio: This measures how much inventory a company holds relative to sales. A rising ratio signals excess stock.
Example: Apparel companies with ratios above 1.5 often face markdowns or write-offs.
Gross margin trends: Declining margins could mean the company is discounting excess inventory to move it.
Example: Fast-fashion brands often report this ahead of a major clearance sale.
Obsolete inventory write-offs: Frequent write-offs are a sign of poor demand planning or mismanagement.
6. Short-Term Debt Spikes
Short-term debt is like borrowing money on a credit card. It works in a pinch but becomes risky if used excessively.
Why it’s a red flag:
Short-term debt requires frequent refinancing, leaving the company vulnerable if credit markets tighten. A spike often signals cash flow problems.
Example: MF Global
MF Global relied heavily on short-term borrowing to fund risky trades. When credit markets froze, the company couldn’t refinance its debt and collapsed.
What to look for:
Current ratio below 1.0: This means the company has more short-term liabilities than assets, signaling liquidity risk.
Example: A healthy retail company might have a ratio of 1.5. Dropping below 1 means trouble paying suppliers.
Cash-to-debt ratio below 0.5: This means the company has less than 50 cents in cash for every dollar of debt, indicating high refinancing risk.
Example: Airlines often face this issue during fuel price spikes or travel downturns.
Frequent refinancing: If a company constantly rolls over debt instead of paying it down, it’s a red flag.
7. Negative Free Cash Flow
Free cash flow (FCF) is the lifeblood of a business. Negative FCF often means the company is overextended or poorly managed.
Why it’s a red flag:
Even profitable companies can fail if they run out of cash. Negative FCF raises questions about the quality of earnings and the sustainability of growth.
Example: Peloton
Peloton’s rapid expansion led to massive cash burn, even as revenue grew. When demand slowed, its negative FCF became a glaring issue, forcing layoffs and restructuring.
What to look for:
Capital expenditures (CapEx) exceeding operating cash flow: This suggests the company is overinvesting relative to its cash-generating ability.
Example: Tech companies often struggle with this when building out data centers.
Negative FCF margin: This ratio (FCF/Revenue) measures how much cash the company generates per dollar of revenue. Persistent negativity is a warning sign.
Example: A SaaS company might have positive revenue growth but negative margins, signaling high customer acquisition costs.
Reading a balance sheet isn’t as exciting as hearing about the latest innovation, but it’s where the truth lies.
Red flags don’t guarantee failure, but they often signal deeper problems. The better you understand them, the smarter your investing decisions will be.
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See you on Sunday!
Matt Allen
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