7 Deadly Warning Signs On An Annual Report

Annual reports consist of equal parts marketing glitz, feel-good platitudes, and hard financial data. After you get past all the hype, plenty of interesting data is just waiting to be viewed and analyzed. As you review the data in an annual report, stay on the lookout for the following seven deadly warning signs:

• Sign#1. Revenues Stagnant or Falling: By comparing a company’s revenues across two or more years, you can get a sense of how fast its revenues are growing. You also can see whether revenues are likely to continue to trend upward in the future. When revenues stop growing—or, worse, begin to fall—this is a major warning sign of trouble within the organization. Stagnant or falling revenues can be the result of all kinds of problems: poor product quality, increased market competition, or internal management problems, to name a few. You have to decide whether this change is a one-time aberration or a trend that’s going to get worse before it gets better. To find out more, search for articles in the financial press that discuss the company and its prospects, as well as prospects for the industry as a whole.
• Sign#2. Earnings Per Share Inconsistent With the Company’s Profit: The value of a company’s stock is to some extent based on the firm’s profitability and the number of shares in the hands of investors. So, if profit increases 15 percent from one year to the next, you may expect the earnings per share of stock to also increase by 15 percent. This won’t be the case if the company dilutes (reduces) the value of the stock by issuing more shares during the course of the year. If earnings per share are lagging behind the company’s profitability, raise the red flag because this requires further investigation. Be aware, however, that stock price frequently is affected by things that have nothing to do with the business itself. For example: institutional investors, concerned about a recent announcement from the federal government, may pull their investments out of the sector, driving the price down.
• Sign#3. Indications of Financial Distress: A company can have phenomenal growth in sales and profit but still go out of business. Have you ever heard someone who went out of business lament that he or she was a victim of his or her own success? As odd as it sounds, it can happen. If a company isn’t solvent — in other words, it doesn’t have enough cash in the bank to cover its current liabilities — it’s in trouble. Run some numbers on companies of interest — specifically, a quick ratio and an acid-test ratio — to see whether they’re solvent. If the results are marginal and the trend is downward, the ratio doesn’t bode well for the future.
• Sign#4. Unusual Gains or Losses: Although every company goes through natural and regular business cycles during the course of months or years, unusual gains or losses can be red flags deserving of your attention. Unusual gains or losses are to be expected from time to time, but they should be just that — unusual. Ongoing unusual gains or losses are cause for concern because they indicate a fundamental problem in the company’s ability to manage its operations and finances.
• Sign#5. Profit Ratios Falling: Because profit is the best measure of success for many companies, growing — or, at minimum, maintaining—profit ratios is an important goal of management. If a company’s profit ratios are falling from year to year, the financial health of the firm is in clear jeopardy. Something in the company is broken and needs to be fixed.
• Sign#6. Adverse Auditor Opinion: For the most part, the letter of CPA opinion is a perfunctory exercise that confirms that a company’s financial statements are accurate.
  Occasionally (today it happens more often because of Sarbanes-Oxley), however, a CPA firm takes exception to a company’s financial results and issues an adverse opinion. Pay close attention to the letter of CPA opinion. Watch for words such as “fairly present” (good) or “adverse opinion” or “reservations” (bad).
• Sign#7. Disconnect Between Narrative and Financials: If an annual report’s narrative doesn’t match up with the realities of the company’s financial position, you can bet that the company’s spin doctors are in high gear. The chairman may go on and on about what a great job the company did in a tough business environment, and about the tremendous prospects for the company in the future. But if the leading financial indicators are pointing in a different direction, there’s more to the report than meets the eye.