Stockopedia academy

Three Investing Red Flags For Stock Pickers

Stock market history is full of companies that promised investors the earth, only to crash down to zero when their red flags were finally revealed to the market. Learn to spot (and avoid) these stocks.

How to avoid stocks at risk of a liquidity crunch

Head of Content
Megan Boxall
Head of Content

Companies that don’t have enough readily-available cash to deal with short-term spending requirements can find themselves at the heart of a liquidity crisis.

Businesses which suffer such a crisis in their immediate funding might have to return to the market for extra cash, or take out a short-term loan with a bank (likely at a high interest rate). When combined with solvency (long-term financing) problems, businesses with liquidity issues are in danger of bankruptcy. Investors who want to avoid companies which rely on regular funding boosters should keep a close eye on liquidity.

This article aims to help investors identify companies at risk of short-term financial disaster. We’ll start by providing an overview of the basic checks investors can make to ensure they aren’t investing in poorly-funded companies, before taking a look at advanced analysis techniques for more experienced investors.

Cash is king

Cash is the ultimate liquid asset. When it is sensibly deployed it can be used to generate more cash, which can subsequently be invested. And so the virtuous circle continues.

But a company’s net cash position needs to be assessed in context. How does it compare to last year? Where has the cash come from (has there been a recent fundraising or is it internally generated)? How does it compare to cash burn?

Take healthcare company Bioventix (LON:BVXP) which is currently sitting on £6m of net cash without any reliance on external funding. The company has very low spending requirements and generates impressive cash profits from its product portfolio. The cash inflows easily cover all of the company’s investment requirements and have supported a healthy dividend.

By contrast, OptiBiotix Health (LON:OPTI) (a peer in the small-cap healthcare market) is repeatedly forced back to the market to top up its cash position. In the financial year to December 2021 the company burned through £1.5m of cash through its operations and then invested a further £200,000 on capital expenditure. By the end of the year it had less than £1m of cash on its balance sheet. When cash burn is greater than the net cash position, the company has a problem. No surprise, Optibiotix was forced to return to the stock market for more funds in 2022.

For larger companies, a better assessment of the cash position can be done using the quick ratio. The quick ratio measures how many times a company can pay its current liabilities with its cash. Financially stable companies should be able to satisfy all their immediate financial obligations with their cash, resulting in a quick ratio greater than 1.

For example, the quick ratio below comes from the current Stock Report of Ten Lifestyle (LON:TENG). The company’s cash position has halved in the last three years and in that time, it has reported significant net cash outflows.

Red Flags / Ten Entertainment - liquidity

Be aware of the interest on short-term debt

Short-term debt is the amount of a loan that is payable to the lender within a year. In 2023 as interest rates rise, companies with a high portion of short-term debt might find themselves on the hook for higher interest payments.

We discussed interest rate coverage in detail in the last red flags article on debtInterest coverage refers to how many times a company can pay the interest due on its debt with operating profits generated in the previous year. If a company has an interest rate coverage of less than 1, it means they can’t pay their interest payments with profits and will then have to turn to their cash stores or borrow more funds to settle the obligation on existing debt.

FTSE 100 group Relx (LON:REL) is considered a high quality business, but its debt has often caused consternation for investors and analysts. Looking at the short term portion of debt, we can see that Relx has about $800m worth of loans maturing in 2023. We can dig further into the notes to see that a further $1bn of debt is due in 2024. Rising interest rates have already sent the cost of borrowing up at Relx so any further changes are worth monitoring.

Working capital management

A company’s working capital is the amount of short-term liquid assets that are readily available to fund day-to-day operations. It is calculated by subtracting the value of current liabilities from the value of current assets.

The current ratio, sometimes known as the working capital ratio, is a measure of how many times a company can pay its current liabilities (such as short-term debt and bills owed to suppliers) with its current assets (such as cash, inventories or equity investments). By rule of thumb, a current ratio of less than 1 is a cause for concern.

The screenshots below come from the Stock Reports of GSK (LON:GSK) and Microsoft (NSQ:MSFT), respectively. GSK has a current ratio of less than 1, meaning current liabilities aren’t covered by current assets. Taken in isolation, that isn’t a good sign, but GSK is a large company and there could be a reasonable explanation for the poor current ratio which could be uncovered by further analysis. Microsoft’s current liabilities are well covered by both cash and current assets. In the event of an emergency, it would be in a more financially secure position than GSK.

Red Flags / GSK - Microsoft - Liquidity

Inventories: Getting the right balance

Inventories (or stocks) are the finished goods that a company has in its warehouses and stores ready to sell to customers. It is considered a current asset because inventory is normally sold soon after it has been produced. Optimising the pace with which inventory is sold is a key consideration for company efficiency.

The proportional value of inventory within current assets depends on the type of company. Software companies, for example, have very low levels of inventory as they don’t have any ‘stuff’ to store. By contrast, manufacturing or retail companies have huge warehouses or stores where inventory is a significant and valuable asset.

There are a few useful ratios to use to monitor the ongoing management of inventory. First up, the stock turnover ratio, also known as the inventory turnover ratio, which is a measure of how many times a company turns over all of its inventory in a given period. Companies with a high stock turnover are generally thought of as more efficient as they burn through their inventory quicker. But beware, a high stock turnover ratio when combined with a low level of inventory could be a sign that a company doesn’t have enough stock on hand and may not be making as many sales as it could do.

The screenshots below show the stock turnover of two giant US companies, retailer Walmart (NYQ:WMT) and car manufacturer Ford Motor Co (NYQ:F). The numbers might be slightly surprising - Ford has a higher inventory turnover than Walmart, which means the car company turns over its inventory quicker than the retailer.

Red Flags / Ford - Walmart - Liquidity

The inventory turnover ratio can subsequently be turned into the days of sales ratio by taking its inverse and multiplying by the number of days in a period. This number gives an indication of how many days it takes for a company to turnover all of its inventory, on average.

The tables below run through worked examples of inventory turnover and days of sales ratio for Ford and Walmart based on last year’s financial statements. Again, the numbers look slightly surprising. Walmart (which largely sells items with a short shelf life) takes longer to collect the revenues from its stock than Ford does. And the figure for the former is weakening.

Walmart

Ford

Revenue (2022/21)

$572.8bn ($559.2bn)

$158.1bn ($136.3bn)

Inventory (2022/21)

$56.5bn ($44.9bn)

$14.1bn ($12.1bn)

Inventory Turnover (2022/21)

8.5 (9.4)

10.8 (10.5)

Days of Sales (2022/21)

43.1 (38.8)

33.9 (34.9)

In 2023, inventory turnover might be an important metric to get to grips with as slowing sales and disrupted supply chains mean many companies are sitting on higher inventory than they have done previously. We can see that this has had a negative impact on the stock turnover ratio at Walmart. Beware companies that might have to sell off that excess inventory at a discount as this could undermine profit margins in subsequent years.

Receivables: Beware sales on credit

Every time a company makes a sale it can book that sale as revenue on its income statement. But some goods and services are sold on credit, meaning the company won’t have actually received the cash for that sale yet. This money owed is reported on the balance sheet as a receivable.

There are two useful ratios to use when assessing a company’s receivables. (We don’t calculate these on the Stock Report, but you can find the receivables figure on the balance sheet of each company’s accounts.) The first ratio to look at is receivables as a proportion of sales. If this is high or rising, it might suggest that a company is being too lenient with the terms of its sales. More seriously, it could also be evidence of accounting manipulation - something we will explore in a later article.

For example, in its last set of financial results British cyber security firm Darktrace (LON:DARK) reported receivables of £68.1m, equivalent to 17% of its revenues. That’s a high percentage for a company which largely sells software. Compare that to US software giant Intuit (NSQ:INTU), whose receivables made up just 3.5% of revenues last year.

The second useful ratio is receivables turnover, calculated by dividing total sales by accounts receivable. It’s a measure of how efficiently a company can collect outstanding balances from clients and a higher figure is generally accepted to be better. Just as with inventory turnover, the receivables turnover ratio can be used to calculate the average number of days it takes for a company to collect the money from its clients. This is known as debtor days and if the number is high and rising, this should be considered a red flag.

The Stock Report screenshots below show the receivables turnover ratios for Darktrace (on the left) and Intuit (on the right). The former takes an average of 62 days to collect cash from its customers, compared to 12.7 at Intuit.

Red Flags / Darktrace - Intuit - Liquidity

It pays to monitor payables

Payables are liabilities that the company owes to its suppliers. These might include bills, rents or lease payments.

Further up the article we looked at the current ratio of two companies and identified GSK’s current ratio as potentially problematic. While it is unusual to see a company of this size with a current ratio of less than 1, it is explained by the fact that the company’s payables are very high. And the reason payables are so high is because GSK is a large reliable company which is offered generous payment terms by its suppliers.

A low current ratio is far more problematic for a small company with a poor track record of satisfying financial obligations. For example the screenshot below comes from the Stock Report of Revolution Bars (LON:RBG). The company has struggled for a long time to cover the lease payments demanded by the property companies where it runs its underperforming chain of bars. In this case, the low current and quick ratios may be a cause for concern.

Red Flags / Revolution Bars - Liquidity

Investors can dig into company payables further by calculating the payables turnover ratio, a measure of how efficiently the company pays its suppliers. A high number shows that the company manages to clear its bills frequently in a given period. The inverse of the payables turnover ratio multiplied by the number of days in the period gives us payor days, or the average number of days it takes for a company to pay all its suppliers. When a company reports a high or rising number of payor days, it could be a red flag that it is struggling to pay its bills.

When a company falls into bankruptcy, all the company’s creditors scramble to get their money back. Unfortunately, stock market investors are at the back of the queue. To avoid such a fate, it pays to closely watch for any liquidity issues at a company, especially if they come alongside red flags for long-term solvency or with any signs of potential earnings manipulation.


Related Content

Financial Engines of a Multibagger
Three Investing Red Flags For Stock Pickers
How to identify stocks with a competitive advantage
How to analyse company growth