Profit warnings only rarely come completely out of the blue, as there are often tell-tale signs that emerge long beforehand. Here are some of the most common warning signs to watch out for.
Communication
The most obvious harbinger of a forthcoming profits warning can be found in the style and content of a company’s communications.
Often a company that eventually announces a profit warning will have given some indication that trading could be a little sticky months earlier. This can come as early as the prior year’s results when it announces that ‘visibility’ on future sales is becoming less clear. Other terms to watch out for in press releases are ‘lengthening sales cycle’ or ‘tough comparatives’ but don’t take these phrases as definitive signs that your investment is in trouble: in the wake of the financial crisis, almost every FTSE 100 company will have utilised one of these phrases. Rather, negative sentiment either in a management statement or other company announcements should be taken as a trigger to conduct further research.
Other warning signs to watch out for can include the delay of interim or full-year results without any comment, or a company with a record for open communication appearing to suddenly clam up.
Financials
Still, the best and most timely clues of a possible profit warning are often found in the financial statements of a company. When analysing its accounts take note of the following warning signs:
Cashflow much lower than profts: As the saying goes, “cash is fact, profit is an opinion’. There are lots of ways a company can manipulate its profits so that it appears to be doing well. For example, using exceptional items to boost profits or treating software development costs as an intangible asset rather than as an expense in the profit and loss statement.Still, the cash flow statement should show if the profits the company purports to make are genuine or have been boosted by financial jiggery-pokery.
Receivables: On the balance sheet, if the trade and other receivables for a company are increasing rapidly, perhaps alongside rising debtor days (the number of days it takes to receive payment for work completed) this could be an indication that possible bad debts are building up.
Notes: Buried away in the footnotes to a company’s full-year results is information that can often give you advance warning of trouble ahead. For example, the company may be involved in litigation or have some contigent liability.
Insider Sales
Large share sales by insiders such as the chief executive or finance director are sometimes an indication that all is not well, particularly if there is no reasonable explanation for the sale (such as a divorce settlement). This is particularly so if the selling occurs when you’d logically expect some buying, following a share price fall for example.
Selling by savvy fund managers may also be an indication that trouble is on the way.
Change of Advisers
The change of an adviser or accountant is another signal that you may want to investigate further. There may be a perfectly good reason for the change but if it isn’t forthcoming on enquiry, it is best to be cautious.
Personal Experience
Your own experience as a customer of a company may also provide some prior notice of poor trading or mismanagement, especially for retailers. Few could have been in any doubt as to the problems facing GAME after visiting its desolate looking stores back in March 2012. Similarly, lack of footfall in HMV together with a rather limited and expensive offering was a reason to fear for it over the course of a number of years.
