Spotting problems with your stock investments
Beginner Stock Market Investing, Online Stock Market Investing, Stock Market Investing Advice, Stock Market Investing Strategies
It is amazing how few people seem to recognise early signs of distress in a company and act to protect their investments. Only a few years ago, both Enron and WorldCom were seemingly prosperous and highly respected businesses with a market value in the hundreds of billions of dollars. As a result, the complete collapse of both companies to their investors by surprise and wiped out the investments of their stockholders. In retrospect, it seems that no investors, including the very large ones, had any indication of what was going on. With a little diligence and some effort, it is possible to identify potential problems in companies that could have a decisive impact on the value of your investment.
One of the most important things to keep track of is the cash flow of a company. Cash should be regarded as the lifeblood of the company and a healthy cash inflow is critical to the survival and the success of the company. If a company has a negative cash flow where the disbursements exceed receipts, their bank balances would deplete rapidly and, without a fresh inflow of cash by way of fresh debt of fresh equity, the company would not be able to make ends meet. Even large and well-managed companies can experience negative cash flows in certain situations. For instance, this can happen if the company is experiencing rapid growth and needs to make fresh and large investments in resources such as manufacturing facilities. There is a time lag between incurring the expenditure and money coming in as a result of increased sales.
It goes without saying that you should critically examine the cash position of companies that are experiencing rapid growth. You will also need to establish the Burn rate of the company (the rate at which it is burning cash) and compare this to the available cash resources to see if the burn rate is sustainable. For instance, in the case of Enron, the burn rate increased rapidly without any inflow of fresh funding.
The other circumstance in which the company can experience strains on its cash flow is when it is carrying high levels of debt. Debt servicing payments can add major problems to companies already experiencing distress with their cash flows. To make matters worse, these companies probably do not have high credit ratings and are forced to pay higher interest rates on their borrowings. This can be measured by calculating the total debt/equity ratio which is the aggregate debt of the company divided by its tangible net worth. Investment experts say that this ratio should not normally exceed 0.5:1 and companies with a higher ratio should be closely watched.
Finally, companies are required by regulation to issue profit warnings and these potential declines in the profitability of the company should be taken seriously. Very often, the market reaction to a profit warning is to punish the share price of the company. Indeed, sharp declines in the price of a stock should be investigated because the market obviously expects a decline in the quality of future earnings. You should also watch out for the resignation or departure of key executives and directors as a sign that all is not well with the company.
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