Monday, February 25, 2008

Hidden Time Bombs that investors should learn to look for

Investing in businesses in the stock market is riskier business than you realise. The American standard accounting practices hide a multitude of sins from the unsavy investor. Companies like Enron, Countrywide Financial and GMAC can be huge titans one day with seemingly positive and healthy balance sheets and gone the next in a sea of debt.

A business may have a healthy dose of working capital and good profitability however it can be very short on money, constantly looking for cash and never having enough.... This can create a long term problem that you will do well to spot today.

Accounts Receivable can severely inhibit a businesses cash flow
Carrying and servicing too much debt can cause cash to dry up

Retained Earnings are a beautiful method of balancing the books, however if the company does not have the actual money the question lies as to where it is retained?

Depreciation is a great way to avoid and mitigate some tax payments, however how does one buy new equipment when the old items have expired (hence the title depreciating assets). Is there a separate account funded by this depreciation write off?

Does the company significantly reinvest in capital improvements? How are these allocated and what is the usefulness of these investments in earning profits for their investors? Did that fancy new office with 5,000sq ft managers suites really increase productivity at all ....... to the same token did the sale and leaseback of the company head office which gave us a great deal of cash this year reduce the overall and long term profitability of the company and deceive investors and managers alike to the problems brewing in the future of the business with reduced profitability?

Share buy backs are great, but were they funded with cash or loans, did VC's come and buy the company with its own assets and saddle the company with debt...this allows them to deploy money, but what will the return be and how will it help the company fuel expansion and growth. Will that growth be in core business and profitability or will it be a mistake? (take Ford who spent Billions of its cash surplus buying into repair and maintenance as the future profit center for the company only to sell it for cents on the dollar and crash the companies stock value)

A perfect example would be Microsoft, who should they deploy they buy Yahoo will become an ideal target to short as they will have to absorb phenomenal costs to integrate the two companies and go through several iterations before problems are rectified, they will also see some serious degradation of their balance sheet as the goodwill values of both companies is absorbed.

One of the biggest give aways though is the share dealings of insiders, these acts must all be recorded and become part of the public domain, if you see key figures SEC Form 4 buying or selling heavily then this is a great indication of a buying or selling opportunity. (look at Angelo Mozilo's 925,815 CFC shares in about 1 year) Do not less this one pass you by, you will never get a better indication of a companies future...

Copyright Jonathan Rose 2007 - Creative Commons License

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