Today's topic is how are you able to identify the 5 red flags in stocks and obtain yourself saved from investing in a very bad company?
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Friends, everyone tells you ways to decide on the best company. On which even I'd have made articles but it's vital to spot a foul company for investing because if you invest during a bad company then there are many behavioural biases which are able to create problems in exiting an organization.
So the most vital thing before choosing a company is to identify these red flags. I won't say that 100% you'll be able to avoid a foul company but you will start having some doubts whether or not you identify one red flag in any of the company.
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Let's start with today's article and discuss the way to identify 5 red flags which might prevent from investing in an exceedingly bad company.
Let's start with the primary red flag. the primary red flag is expounded to a company's debt and its liquidity.
Now how are you able to identify them and the way do these two things matter in your investment?
Now if I start with debt, then you'd possibly know that when a company takes money from a third party so on expand its business or meet its requirement, it had to pay interest on its debt. it's said that debt is extremely important for any company's expansion but it should be taken in an exceedingly very limit.
Friends, now the question here is what's the applicable favourable limit of debt in any company?
This question cannot be answered by an expert or analyst. This decision as an analyst you will take. I can give you small tips to identify if the debt level is suitable for the company or not. The debt level is different for every industry in some industries, it's possible that a debt level, debt to equity level of 0.1 is additionally considered high. In some industries, even ratio of 1 in debt to equity is taken under consideration low.
If you're analyzing debt to equity ratio of a corporation as compared with its industry, if it's appropriate or not then pick 5 to 7 competitors of the company and remove the common debt to equity ratio, Compare it to figure out if a company's debt-equity ratio is higher or lower in line with the industry. Normally it's considered if the debt to equity ratio is lesser than the industry then it's ok.
Otherwise, it isn't okay, yet another parameter will be analyzed in the debt's comparison. If an organization is taking a debt, what's the reason behind it. Company is doing it to expand its business if its revenue growth and profits are increasing then it seems right that the business took debt to expand itself. Now assume if a corporation took debt within the half-moon and its revenue and profit don't seem to be increasing and within the next quarter, the corporate took more debt reason behind which the company's revenue and debt didn't increase by much. If you are feeling that the revenue and also the profit of an organization isn't growing well but its debt is increasing continuously in such a case you ought to be awry and consider it as a red flag and keep one's distance from such companies if still, you wish to speculate, then a minimum of you ought to select a deeper analysis then you ought to decide whether you wish to take a position or not.
Friends, another thing which is as important as debt is liquidity?
Liquidity means what proportion of money does the corporate have which it can convert into profit the short term. Liquidity is vital for any company's operations. you'll observe a company's income, operations. Normally you must see that the company's income is positive, not negative. another important measure to investigate liquidity is debtors cycle.
Now what's this debtors cycle and what does it indicate?
Now say I own a company which manufactures bags for distributors. Now if the liquidity of the company is nice then I will be able to have more money and that I can manufacture more. Now how can the liquidity get better? Say if I'm manufacturing bags to provide it to my distributors and my distributors pay me my amount in 5 days.
Now debtors cycle tells you in what percentage days the distributors return the money on an average. Now consider that the company's debtor cycle is long and it takes a protracted time for the cash to be paid then, in this case, the company can experience a liquidity crunch when there's a liquidity crunch in an exceedingly company, the assembly of the company gets impacted and to scale back that liquidity crunch, the corporate creates more debt and you recognize how dangerous it's for any company to require debt.
Let's speak about the second red flag which is expounded to promoters holdings.
Friends, you may know a company's promoter holding is often worked out from any related website, which tells you the way much of the ownership is being held by the promoters within the company. within the industry, if the promotor holding of a company is continuously increasing it's considered to be a positive point but to only invest on this basis would be wrong.
There is a significant red flag within the case of promotor holding which you need to consider there's a thing called promotor pledging which tells you the way much of its share is loaned out by the promotor. Now from here, we are able to understand that if the promotor needs money & he can loan out his share within the company and find money.
Friends if in any company the promotor holding in pledge is increasing continuously. It is a red flag for you and you want to further investigate that the shares pledged by the promoters are for what period of time and the way is the visiting utilize that money for if the pledge is continuously increasing then after considering it a red flag and doing further analysis only you must think about investing in a very company.
Other than this if the company's promoter holding is decreasing at an increasing rate which means promotor is exiting from the company and even, therein case, you need to do a deeper analysis on the reason for the matter that the promotor is exiting.
Friends, there are some regulatory compliance because of which promotor has got to decrease its holdings, so you'll be able to overlook those cases so you need to analyse on why the promotor decreased his holdings, what's the explanation given behind it?
You should do a deeper analysis in such a case and if you discover justification for this example then If promotor reduced his holding or pledged it thanks to compliance or the other genuine reason then it's ok. If that's not the case, then you need to do an additional analysis after considering it a red flag.
Let's speak about the third red flag which is incredibly important if you're planning on investing during a financial institution.
NPA is the 3rd Red Flag which tells you about Non Performing Assets. I'd have told you its definition in every banking article. NPA tells you that if you have got lent Rs.100 then what proportion money would become a foul debt there. This tells you asset quality during a particular bank's lending which suggests if a bank has invested in an area, then what are the probabilities that it'll be returned.
Recently, NPA has began to be considered vital because assume if a bank is lending out aggressively and growing aggressively then you would possibly feel the necessity to take a position there. A bank's core income comes from the interest within the invested amount.
Now assume if the bank has stopped receiving interest also because the bank's money is additionally not getting returned then you'll imagine the pressure on the bank explanation for which NPA should be a vital red flag for you.
If any banking institute's NPA is growing at an increasing rate like within the case of Yes bank when it had been trading at Rs.300 its NPA was continuously increasing as its asset quality wasn't good explanation for which there was a downfall thanks to which retail investors faced an enormous loss thus within the banking sector, NPA is incredibly important.
Before investing in any bank, you want to undergo its past records and where it's lent its money & what quantity money is in corporate and retail, & it's normally considered that the bank which has more investment in retail has lesser NPA and by investing in corporate the NPA increases take this stuff into consideration and analyse deeply before investing in any banking sector institutions. If the NPA is increasing continuously then consider it a red flag and avoid such companies.
Friends, let's discuss the fourth parameter
Assume if a company's last quarter's result was excellent & its profit has increased heavily, in such cases people think they ought to invest in such companies cause within the recent quarter its result was excellent. If you're viewing the quarterly results of a corporation and analyzing then take a look at the past 3 years results. If you're watching one quarter's results then if you're looking 2021's half-moon results then you need to compare it with the identical quarter of last year.
Say if I checked out March's result then I can compare it with December results but there are many companies with seasonal businesses. Now assume there's a corporation which gets huge sales in March and if you compare it with December. you will not be able to see a real picture and while analyzing any quarter's results.
Say, for instance, you're analyzing the results of March 2020 then compare it with March 2019, so you'll be able to counterbalance the seasonality in any business and acquire a real picture on the earnings. While analyzing the earning, check the operating gross margin rather well and don't invest in any company on the idea of profit.
It might happen that the revenue of a corporation grew rather well but its operating gross margin wasn't good in this case, there may well be some serious issues with the corporate.
Now here if I provide you with an example, you would possibly have heard of Ruchi Soya. When Ruchi Soya got listed after getting delisted once, the red flag one saw before visiting NCRT was that the company's revenue was growing fine but the company's operating profit was very low at 2 to three. If you're reaching to invest in a very company with a decreasing operating profit then it should act as a red flag for you which ones you ought to analyze deeply before investing.
Friends, let's discuss the fifth red flag.
you might understand how important quarterly and annual results are for an organization because it tells the shareholder about the performance of a corporation. In some cases company starts delaying its quarterly and annual results and if you're thinking of investing and you see that the corporate is, again and again, delaying its annual results even it can act as a red flag, cause if you decide out a decent company and see, you'll notice that they never delayed their annual results.
Just after their committee meeting, you receive their annual reports, You should notice before investing during a company on whether or not they are publishing their annual results on time apart from this, accounting policies are very tough which might change your profit & loss in some ways, so if you read the annual reports of a corporation rather well then you ought to know which accounting policies the corporate is using and during which way the corporate is recognizing their revenue and expense.
Now, assume if an organization is changing its accounting policies frequently so as to indicate more profit then considering it as a red flag, you ought to keep one's distance from such companies.
How a company uses its accounting policies may be seen in its annual reports?
Below the annual report, you'll see the accounting policies well wherein they tell you on what are their revenue recognition policies, depreciation policies, accounting policies within the company. you must check it out thoroughly very well If a corporation is changing its accounting policies frequently and delaying its quarterly results then it should consider it a red flag and a deeper analysis should be made.
Friends, today article was completely for educational purpose, If we've taken any company's name within the article as an example, it's just for educational purpose. We don't recommend on buying and selling in any company. If you liked this article then Comment and tell us which red flag have you ever used before and which companies come there under the red flag. You can even advise us on which topics we must always make an article on. If you have got not subscribed to DEV’s Invest Notes channel yet then Subscribe It in order that you do not miss any of our articles. And you can visit our official website WODS OFFICIAL.
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