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Fundamental analysis is a powerful tool to analyze companies and make smarter long-term investment decisions. However, it can be quite overwhelming for beginner investors, there is an infinite amount of data to look into and many variables to analyze.
Financial metrics are shortcuts to know whether this company is in good financial health and maybe a good investment opportunity or that you should skip it.
We will look into three major red flags in the company’s financial performance that if you saw, then you should be skeptical and consider avoiding it even if the market sentiment disagrees.
- Too Much Debt
- Decreasing Operating Cash Flows
- Low Return on Equity (ROE)
Too Much Debt
The Cost of debt is usually lower than the cost of equity but taking on too much debt will cause the cost of debt to rise. This is because the biggest factor influencing the cost of debt is the loan interest rate.
Provided a company is expected to perform well, debt financing can usually be obtained at a lower cost.
A company with a lot of debt will have a very high debt/equity ratio, while one with little debt will have a low debt/equity ratio. Assuming everything else is identical, companies with lower debt/equity ratios are less risky than those with higher such ratios.
A too high debt-to-assets or debt-to-equity ratio without a valid reason like a megaproject launch can be a red flag that you should consider before investing in this company.
Decreasing Operating Cash Flows
The cash flow from operating activities/operating cash flow provides the amount of cash made from the core business activity over a period of time. A successful business must generate most of its cash from operating activities.
A decreasing cash flow is usually a result of either a decrease in net income or a decrease in working capital, the difference between a company’s current assets and its current liabilities. Negative operating cash flows indicates that the company is not yet able to generate cash flows from their core business (operational) activities.
It’s important to check this metric during the past 3-4 years of the company. If it’s growing then it’s a positive sign that the company is operationally in good health, if the opposite is true then it is considered a red flag with the company’s cash collection and you need to investigate it further.
Low Return on Equity
Return on equity (ROE) indicates the company’s profitability in relation to the shareholders equity. In other words, it measures how efficient the company in generating profits for the shareholders. It simply means how much profit the entity could generate per amount invested.
A Low or decreasing ROE indicates that the company is not able to generate profits for their shareholders due to operational inefficiency or bad capital structuring.
Generally, when a company has low ROE for a long period, it simply means that the business is not very efficient in generating profit to its shareholders
What is considered Low or Too much?
A question you might ask is what is a low ROE? What is too much debt?
There’s no one answer for such a question. A good ROE or Operating Cash Flow level varies depending on the sector/industry of the company. You should compare the company only to other similar and industry peers. This is because some industries might have higher ROE in general, but also depend heavily on leverage, while other industries don’t have such cases.