Reports of slowing growth or earnings declines can severely punish a stock’s price. So you aren’t surprised by this type of news for your stocks, look out for these three warning signs when you review financial reports:
Accounts receivable represents amounts owed to the company by customers for goods received. Receivables typically track sales, so as sales increase, receivables increase and vice versa. When accounts receivable start to increase significantly faster than sales, find out why. Some possible reasons include the company is not following up with slow-paying customers, customers are withholding payments due to product dissatisfaction, customers don’t have the cash to pay bills, or the company is providing longer payment terms to increase sales. All of these situations can forewarn potential problems.
Gross margins represent the profit made on products before considering overhead, marketing, and research and development costs. Declining gross margins mean either that the company is cutting prices to maintain market share or production costs are increasing and the company can’t increase prices to compensate. Both are warning signals for future earnings shortfalls.
Reported earnings are based on numerous accounting decisions, which can change over time. Cash flow, however, measures how cash has flowed in and out of the company’s bank account. Thus, it is often viewed as a better gauge of results than reported earnings. If net income is increasing but cash flow is decreasing, this could be a sign of a potential problem.
Just because a company experiences one or more of these red flags doesn’t mean it will necessarily have sales or earnings disappointments in the future. However, if you find these situations, review them carefully to ensure there is an appropriate explanation.