It is said that no company suddenly falls into bad times. Be it Satyam, Kingfisher or Deccan Chronicle; in all these cases the warning signals were there well in advance. In every case the symptoms of financial distress are available well in advance. From an investor’s point of view these are important because they forewarn you about impending problems in a company. You can readjust your holdings accordingly. So, what exactly are the early warning signs of company distress? Above all, how to analyze company financial performance and are there are any such clear indications that a company performance is deteriorating?
Ten clear signals that a company’s financial performance is deteriorating..
The ten signals mentioned here may not be exhaustive but they are largely illustrative for the purposes of analysis and for protecting your investments..
1. Are we seeing a sharp drop in revenues? OK, we are not talking about an industry like the oil industry wherein the revenues fall and rise with the price of crude oil. But look at sales volumes. They tell you a much better story. If you seeing the sales number fall quarter after quarter, there is clearly a problem either n the business model or the quality of the product. Take that as a warning signal.
2. Is the company delaying payments to creditors? This is a classic giveaway. When a company starts to default on regular interest payouts, principal repayments and starts getting downgrades from rating agencies, it is time to be careful. It means the company is not able to earn enough from operations to service its debt burden. This is a major financial risk for many Indian companies.
3. Is the company defaulting on statutory dues? These kinds of stories hardly remain hidden. Normally, companies tend to pay their statutory dues like advance tax, PF deposit, GST etc on time to avoid any regulatory hassles. When a company starts to delay on these statutory dues, then you can be rest assured that there is something seriously wrong with the operating metrics of the business.
4. Are there delays in employees salaries? This is again a very obvious giveaway. We do understand the occasional delay but most companies are very touchy about their reputation when it comes to employees. Companies like Kingfisher were defaulting on salary payments much ahead of their actually bankruptcy. This is a very simple case of a company in a state of financial stress.
5. Be cautious when there are too many red flags in the annual accounts of the companies. You can to see that in the qualifications made by the auditors. You can also get to see than in red flags raised by the analysts and fund managers. Additionally, you will also find the media reporting about such matters. These are indications that the company in question is trying to be as opaque as possible. Normally, company do not resort to opacity unless they really have something to hide. Take this as a warning signal.
6. When you see a huge churn at the top level of the company. The occasional exit at the top is quite normal in most companies. But if you see the CEO, CFO and the CTO resigning from the company within a short period of time, then there obviously something you need to worry about. Such an event happens only if they smell something serious wrong and do not want to be a part of the sordid story. Take that as a warning signal that something negative is likely to come out about the company and prepare you accordingly.
7. Are institutions dumping the stock? This normally does not happen just like that. Of course, institutions have gotten out of stocks like L&T and Tata Steel ahead of their down cycles but that was a different ball game altogether. Obviously, we are talking about smaller companies that are seeing an exodus of domestic and foreign institutional investors. You can get the warning signals from the bulk deals on the exchanges that are reported daily. Transfer of stake from one FPI to another FPI is OK. But if you see all FPIs wanting to sell or all MFs wanting to sell, then it is not a good sign.
8. Are promoters gradually exiting their stake in the company? We have seen that in the case of companies like Himachal Futuristic where the promoters gradually reducing their stake. This can happen through direct stake sale or through financers selling the pledged shares. If you feel that after the stake sale the company will just be left as a shell, then you are better off exiting the company well in advance.
9. Is the company performance deteriorating vis-à-vis its competition? That is the first warning signal. We do understand industry level changes and risks. But what if other players are doing well but this one company is losing market share and profitability. Take that also as a very serious warning signal.
10. Finally, look at the return rations. These ratios hardly every lie to you. Look at the ROE, ROCE, ROA, NPM, OPM etc. If you find steady deterioration in all these variables then you are better off exiting the stock. Also be cautious if the efficiency ratios are deteriorating. A company that is not using its assets properly is unlikely to sustain in business for too long.
In most of the cases where companies went under, there has been deterioration in more than one of the above factors. As investors, if you keep an eye on these 10 indicators it is likely that you going to be in a much safer position.