CHENNAI: While a large number of people opt to invest in mutual funds when they want to dabble in the stock market, some actually decide to try out the direct route, buying stocks of a particular firm/firms on the stock market. However, such investments require investors to pay a much larger chunk of attention on the company/companies they have invested in to safeguard their asset value.
But what are the most important signs that a company you have invested in is in trouble?
Contracting net profit margins
A company might be earning huge amounts of profits, but a declining net profit margin is a sign that the company might be heading into rough patches.
Calculated by dividing net income with net sales, it gives an idea of how the company is managing its expenses.
Thin liquidity ratio
While many companies, especially ones in heavily indebted sectors like power and infrastructure have had no choice but to sport very little liquidity, it is a sign of a sick firm if it’s short term assets are not enough to pay off all its debt.
A liquidity ratio of below 1 is a sign of a sick firm. It is calculated by dividing current assets with current liabilities.
Slow inventory turnover
This is a no-brainer for any investor in a product manufacturer. If your company is struggling to convert its inventory into sales fast enough, it is not seeing high enough demand for its products. Unless the entire sector is going through a lean phase, which is bad enough for dividends, a slow inventory turnover is a sign of trouble.
Constraint-free cash flow
Free cash is essential for the smooth operations for any firm. If cash flow is tightening, the company is heading for, or is already in, trouble. Free cash flow is calculated by subtracting capital expenditures from operating cash flow. A negative figure indicates that a company was unable to generate enough income to support its business/expansions.
Inability to meet interest payments
One of the largest signs of crisis in a company is if it has trouble meeting its interest payments. Mounting losses, no profit margins and tight cash flows generally do not give companies a cushion to pay off their interest obligations for debts taken.
Generally, companies need to have more than enough cash left over to keep its creditors at bay. But, in companies that are failing, or about to fail, that cushion gradually wanes, and they are just barely able to make their bills.
Top management quitting
This is also a sign of trouble because a string of senior management people leaving the firm generally want to leave a sinking ship. If too many senior management leave, it’s a sign that you need to look a little closer into your investment.
Institutional investors dumping stakes
While big institutional investors generally juggle their stock portfolios and might dump stock with one company and take up another, even if the former is perfectly healthy, big institutional investors hiving off their stakes can also be a sign of nervousness in a company’s ability to perform. Many such stock sales happen a few months before a bankruptcy filing or other financial trouble.