I wrote yesterday about 9 signs I look for that indicate a company might be heading for trouble.

The key indicators I look for include:

  • Falling profit margins
  • Negative free cash flow – paying out more in capital expenditure than it received in cash from ‘business as usual’
  • Frequent capital raisings
  • Falling returns on equity, assets and capital
  • Rising cost of doing business – costs of raw materials, employees and other costs increasing faster than revenues
  • Rising levels of debt
  • Falling interest cover – the size of a company’s profits compared to its interest costs
  • Rising or very high levels of intangible assets
  • Frequent reporting of negative “one-off” items

After outlining some examples of where these signs might have save investors (including me!) from trouble, I’ve also uncovered some companies that share these traits – suggesting investors should tread carefully, and the reasons why.

Potential candidates

Transfield Services Limited (ASX: TSE) – very slim profit margins, large increases in share count, large levels of debt, very low return on equity, assets and capital employed.

Hills Industries Limited (ASX: HIL) – again very slim profit margins, low and falling returns on equity, assets and capital employed. The maker of the ubiquitous “Hills Hoist” is my tip for a takeover in the near future. I can see the news reports already, “Yet another Aussie icon disappears overseas.”

Gerard Lighting Limited (ASX: GLG). Having only listed in 2011, Gerard Lighting already exhibits some of the warning signs. A low profit margin of 4.5% in 2011, rising debt levels, intangible assets represent 74% of net assets and have been rising.

Qantas Airways Limited (ASX: QAN). Perhaps controversial, but the only thing keeping Qantas in the air is the company’s management. Somehow they have managed to keep the airline profitable, but eventually I can’t see it ending in anything but a crash. The company had profit margins of 1.7% in 2011, low and falling returns on equity, assets and capital employed and high levels of debt (Qantas had $4bn of off-balance sheet debt in 2011 to add to its $2.5bn of net debt). Since 1998, Qantas has been to the markets to raise over $2b in new share capital, and the share count has almost doubled from 1.2b shares to 2.3b.

The Foolish bottom line

No one metric (or indeed combination of metrics) can predict success or failure, but the old adage of smoke accompanying fire is true for a reason. Accordingly, investors would be wise to double-check their investment theses when a prospective or current investment candidate exhibits some of these warning signs.

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More reading

Motley Fool contributor Mike King doesn’t own shares in any of the companies mentioned. The Motley Fool’s purpose is to educate, amuse and enrich investors. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson. Click here to be enlightened by The Motley Fool’s disclosure policy

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