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There is no sure-fire way to spot a company in trouble, so how can an investor cover himself? Peter Webb serves up the recipe for catching the red flags early

Last week we examined how profit warnings seem to follow one another and the reasons behind that. Knowing why this sort of thing happens is useful but unfortunately you cannot invest retrospectively. What areas should you examine if you want to spot future potential profit warning scenarios?

My first piece of advice is pick up an annual report and when you pick up that annual report, immediately turn to the last page and work through the report backwards. It may sound odd but all the really useful information is held in the notes to accounts and other such detail. It is from there that you can often identify issues. I have drawn up a short list of things that you can use to spot potential problems. Further to our discussion last week they can be generally split into accounting and operational issues.

Accounting issues

• Inspect the revenue and expense recognition policies – Determine whether it is aggressive or not. While all policies can be well within the framework of acceptable accounting policy some companies are typically prudent while others may be seeking to find the edge of acceptable policy. Look at similar companies and compare their policies to determine this. Pushing the boundaries may reveal underlying pressures.

• Asset quality & Capitalised expenses – Capitalisation involves booking expenses as an asset and writing them off over its useful life. This is a perfectly acceptable policy as all costs and sales should be recognised over the period in which they are used. However, high capitalised costs may mean the company is shielding the true cost of business. It could have paid too much or it may just have taken a far too optimistic view of the period over which these assets should be written down.

• Intangible assets – Intangible assets on a balance sheet could indicate a number of scenarios and they are worth examining in detail. Intangibles on the balance sheet can represent goodwill from buying a company but could also represent capitalised assets or variants thereof. In each case, you need to carefully qualify the ‘true’ value of these assets and how they are being accounted for and written off. Some companies regularly engage in write-offs and reflect this on their earnings reports as ‘one offs’. It is worth checking how often the ‘exceptional’ write-offs occur. It could be this that links to over use of capitalised expenses or just plain understatement of the true costs of doing business.

• Investments in associates and joint ventures – Try to avoid companies that take significant investments in associates and joint ventures and then derive income from them. Inspect the fixed asset note to see if the company is increasing its investments in these areas. Sometimes you will find that they offer loan guarantees to these subsidiary companies. If the subsidiary is making a loss then the company is effectively massaging losses.

Operational issues

Rapid sales with slowing inventory or debtor turnover – It is important to look for the trend in these figures. Rapid sales accompanied by significant slowing in inventory and receivables turnover, may indicate ‘channel stuffing’, bad credit quality of customers or erroneous and premature booking of sales before customer acceptance. Companies anxious to hit aggressive sales targets may ease credit policies, or get customers to accept too much product in return for easy credit. This robs from future performance and suggests growth is not being maintained at the same pace as the expectations that have been set. This can mean a real disaster in the making. A lot of growth companies fall into this trap.

It is worth explaining ‘channel stuffing’ further. Companies desperate to meet sales and earnings targets can stuff their sales channels, their routes to market, full of stock by giving favourable terms to their customers who hold their stock. Come financial period end, aggressive sales forces often invoice everything they can. Some even send out goods on sale or return or some other rotation agreement. You can get away with it only as long as the product ends up selling through. If not, then the product could be on the way back to the original supplier and they could face heavy markdowns of the inventory in channel to ensure it stays sold.

Channel stuffing has the effect of robbing turnover from future periods to feed the current period. In an industry suffering from price deflation, this can also lead to significant over valuation of stock in channel or in stock. The longer it stays unsold, the less value it will hold.

Solving the puzzle

While any of these potential issues in isolation or together are not sure fire indicators of a company in potential trouble; you can use them to put together a clearer picture. Think of each as part of a jigsaw puzzle, as the picture forms you can easily decide if you like what you see and whether it feels right.

Next week we will look at an example of a company that was struggling. While there were mitigating circumstances that started this trend, the details showed up in the accounts. So even if you were not sure that the key event would cause a problem you should have been easily able to identify the inexorable slide into trouble.