If I were to create a list of signals for investors that should say “run away”, or if I were to suggest to a business the things they should never allow to become a trend in their financial reports then they would have to be these seven things. I will exclude fraud in this discussion. It is my personal belief that in today’s investment climate the lowest risk companies are also the highest performing shares to buy.
The characteristics of the opposite (high risk businesses) are these among others:
1. Slow inventory turnover
Measured with a ratio or another way, Inventory that tends to stagnate in part or as a whole shows that the business is not selling it. If it is not selling it is either wasting or becoming obsolete or simply attracting warehousing costs. The theory of cash conversion cycle fits into enabling one to analyse how long it takes to generate cash from typical business operations. These can be compared to previous periods, or to similar businesses, or to industry averages.
2. Collecting money owed by debtors too slowly
How slow is too slow? Too slow is any time longer than the rate at which suppliers (or creditors) are paid. The difference in timing means that the business is paying out cash quicker than it receives it. This in the extreme cases can cause cash flows to disappear and debts to increase. Accounts Receivable should be monitored with ratios or other means and not allowed to move at a slow rate. The delaying payment is not an excuse not to pay creditors, or incur extra charges due to late payment or lose out on discounts – only to ensure that the time value of money principle is applied correctly.
3. Paying suppliers too quickly.
Paying creditors before the last sue date has several disadvantages. The first is that the business does not have enough time to collect it’s own money from it’s debtors. Even if the business does have the funds to repay the creditor it should still try to hold on to the money until the settlement date to earn interest. The money could be invested in temporarily covering overdrafts or being invested for interest in short term investments. The interest earned (or saved) represents an additional income or cost saving that will improve the appearance of the income statement.
4. High levels of debt
The higher the proportion of debt the more likely a business is to fail because of the cost to maintenance the debt. Debt is often sensitive to interest rate movements which impact the highly indebted businesses more so than those who mostly consist of owner’s investments. Simple ratios such as Debt/Asset can give indication done by dividing the Total Liabilities by the total Assets of the firm. Many other ratios exist to help see how well the business can cover it’s interest owed. Signs of excess debt include negative net cash flow on the statement of cash flows (regardless of profits declared), high debt to asset ratio, interest paid exceeds interest earned for the period (for financial institutions), high leverage ratios, and others.
5. Market mis-pricing
Businesses sometimes price themselves out of the market and this causes their sales to collapse. Some businesses such as strict franchisees are not in control of their prices and have to hope that they are priced correctly. This causes franchises to be successful in specific income earning regions and unsuccessful in others. Other businesses are in control but are not sensitive to the changes in demand and supply of the product they trade. Sometimes a 50% decrease in price can increase overall sales by 26% – the end result is more profit. Other times, businesses have to take advantage of supply shortages and increase their prices.
6. Poor use of assets
Asset misuse is comparable to hoarding and relates to idleness and underutilisation of what is already under control and paid for. Assets which could generate revenue if they were leased out, or sold, or removed from lease agreements to save costs. In short every square centimetre that does not produce revenue needs to be revisited.
7. Mistiming and poor forecasting of cash flow
Businesses in trouble are often those who have not planned assets at the right time to cover their liabilities which were either certain or highly likely. Also those who base their decision on unrealistic expectations such as investing in the hope that it will generate returns without sufficient research and testing done first.
This is often because planning function does not exist, or not enough time has been dedicated into planning. It is important to make provision for future expenses that are known and timing them with incomes which are certain, this would mean making the money available when it is needed and investing it when it is not so that the maximum returns can be achieved.
As I have mentioned these are some signs among many others. However, these are the sure overall principles used over time by investors to test business performance.
International accounting policy can change but the underlying principles do not. It is important that every business only act in a way that is profitable to act, and if there is no profit to be made with an action, then it is not profitable to act at all.