Friday, February 11, 2005

Financial Red Flags

The guy I share an office with at work sells candy and Coke out of his desk and a little refrigerator. (My managers obviously don't read Joel on Software.) I know that he has a very loose accounting system, but I thought it would be amusing to imagine what sort of things he might be on the lookout for if he did keep track. Obviously revenue and earnings would be high on the list. If he found out he was losing money or fewer people were buying stuff, he might get concerned. These are basic, but how might he notice the trends earlier? What red flags would warn him of trouble?

My coworker buys his wares when they go on sale at the grocery store and sells everything for 50¢. His profit margin depends exclusively on how much he pays for the stuff he sells. If the grocery store raises prices or people buy more of the expensive items, his margin would go down. If he raised his prices, his margin would go up, but his sales might go down. So changes in margin over time are danger signs.

The office store's best selling item is Diet Coke. As it turns out, diet sodas go bad over time because the sugar substitute breaks down. Most of the time, this isn't a problem because people buy the stuff almost before it gets cold. But suppose there was a big sale at the grocery and some of the best customers went of vacation for a few weeks. It's possible some of the Diet Coke could go bad and have to be thrown out. On the other hand, if inventories got low and our office had a bunch of late meetings, the store might lose sales because it runs out. Inventory changes are potential problems.

Most people pay as soon as they buy from the store. A few people put in extra so that they don't have to deal with paying a few hours later. But some people run a tab or use IOUs. Unfortunately, people aren't always honest, sometimes forget how much they owe, or leave the company before repaying. These risks increase as the amount owed increases. On the other hand, if my coworker forced people to pay as they go, he might lose some sales, so changes in receivables (either increases or decreases) are worth investigation.

Suppose my coworker decided to buy a bigger refrigerator. Since the business doesn't make enough to pay for one out of its cash flow, he'd have to borrow money. In and of itself that isn't a bad thing, but it would be important to monitor how big an impact the new equipment and new debt is making on the sales and earnings. Big spending projects, especially those that involve adding debt, should be watched closely.

All of these are extremely simple to monitor in public companies, just by reading the most recent quarterly report. The mainstream press rapidly reports earnings and sales, but rarely digs much deaper. But simple danger signs like this can warn of trouble a quarter or two in advance. I plan to go over all the companies I directly own to see what signs or trouble they might have.

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