Over the years, you may have seen businesses expand their footprints, increase growth rates, and provide superior returns to investors. And at the same time, many companies have failed, destroying investors’ wealth. It’s easy to spot those businesses with high growth potential, but how do you spot failing stock market companies with a higher chance of failure?
There are warning signs that can help you detect fraudulent or failing stock market companies early. You should always track these early warning signs for your businesses/or the stocks you are invested in or looking to invest in. It will help you to protect your capital and become a more sensible investor instead of following the crowd.
The following are the seven warning signs that you should look out for.
The company finds it difficult to service debt or restructure its loan
When the company finds it difficult to service its debt or opt for debt restructuring, it’s a tell-tale sign that it is in a financial crisis. The company’s income statement will show whether it has met all its debt obligations or not.
One of the metrics to follow is the interest coverage ratio, which tells how well a company’s earnings can cover its interest expenses. Generally, stock and business analysts prefer an interest coverage ratio greater than 1.5x. If the metric is declining quarter-on-quarter and below 1x, it is a warning sign for you to relook your investment.
Negative cash flow statement
While reviewing the company’s financials, it’s a sign of caution if you find out that the company is burning through cash to meet working capital expenses. Compare the current cash flows and cash holdings of previous quarters to determine the extent of cash outflow.
You should note that not every time, negative cash flow is terrible. For example, if the company is spending cash on investing activities, it could mean it is investing in improving its future growth potential. However, you should be concerned if the cash flow from operating activities shows negative cash from operations.
The company frequently switches auditor
Public companies must have an external auditor audit their financial books, who will certify the genuinity of all financial records. Generally, companies prefer to continue with the same auditor for a long time. Still, if there is an abrupt dismissal of the auditor or they switch auditors from time to time without valid reasons, it is a big red flag and can indicate corporate fraud.
Another scenario is when the auditor refuses to sign the business’s financial statement, you must investigate the reasons for refusal before investing.
The high employee attrition rate
It’s natural for companies to witness employees leaving for better opportunities. However, when the company sees a higher attrition rate which stays elevated for the next few quarters, it indicates a poor working culture or inefficient management. Also, a series of defections in the top leadership team should ring an alarm bell in your head.
Falling customer reviews
Whether it is a small or large business, customer reviews shape the company’s future growth potential. Conversely, if customer reviews are negative and falling, it indicates lower customer interest in the business, which can impact future profitability.
Look for businesses with excellent consumer recall and good customer reviews over a long period. If people are not talking about the company, identify what’s wrong with the business before investing.
Big insider selling
Promoters buying stocks from the open market is a good sign, as it indicates greater confidence in better financial performance by the company. However, when promoters sell a big chunk of their stake in the company without any reason or institutional investors start dumping stocks, the smart money is moving out, indicating trouble in the company. So always be on the lookout for insider trading news and avoid stocks where promoters have pledged a significant part of their stake in the company.
Cut in dividend payouts
All publicly listed companies have a dividend payout policy their board must approve. It is often bad news if a company cuts down on dividend payments against the approved payout policy. It indicates reduced earning, higher debt, bleak performance outlook, corporate frauds, and more.
But a dividend cut may not always be negative news for investors. For example, the company can hold out on dividend payments if there is significant capital expenditure on a new project, acquisition, or stock buyback. You should always look for companies with stable dividend payout before investing in their stocks.
Bottom line
Corporate frauds are common and getting extremely sophisticated every day, making it impossible for investors to identify the warning signs. However, the basic level of checks on the company, comparing the company’s performance with overall industry performance, and closely following all the developments can help you to identify the early warning signs of failing stock market companies.
Before investing in a company, spend considerable time understanding the business, its market, financial performance, management, and whether or not the administration is walking the talk. It will give you many answers about the business’s future performance and help you stay away from failing stock market companies.