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Stepan Lavrouk
Stepan Lavrouk
Articles (610) 

The Value Investor's Handbook: Two Warning Signs to Look Out For

Keep a look out for these red flags

June 25, 2020 | About:

One of the biggest stories of the last few weeks was the news coming out of Germany about the payment company Wirecard (WDI), which was found to have misstated its cash balances by a whopping €1.9 billion ($2.1 billion).

Although there had been a cadre of intrepid shortsellers and journalists who had been warning investors about irregularities in Wirecard’s accounting, the news clearly came as a shock to the majority of investors, with shares of the company collapsing over 60% on the morning the news broke. This incident raises the question: what warning signs should investors be on the lookout for in businesses? Here are two of my go-to metrics..

Too much goodwill

Goodwill is an accounting measure that represents intangible assets that are left over from the acquisition of one business by another. For instance, if a company with net assets of $100 million is acquired for $200 million (maybe it has a very strong brand that the buyer is willing to pay a premium for, or an excellent customer base), the $100 million difference is recorded as "goodwill" on the buyer’s balance sheet.

This is a necessary abstraction in accounting. However, it is inherently a slippery metric that unscrupulous management teams can game to great effect.

Excess goodwill - particularly relative to shareholder equity - is an indication that a business has been expanding rapidly, which on its own is somewhat of a warning sign. Unlike fixed assets like machinery and real estate, goodwill can disappear quite quickly if it needs to be written down. This will have a detrimental effect on the size of shareholder equity, and therefore the share price.

Bad current ratio

The current ratio is a measure of a company’s liquidity. It is calculated by dividing current assets by current liabilities, and - in a nutshell - it tells you something about a business’s ability to pay its short-term debts. It’s a fairly crude metric, but it can give you an indication of whether something might be wrong, prompting deeper study. If you are looking at a company with a bad current ratio (say, below 0.75), then you might want to look at whether it is able to pay its short-term obligations.

Look for disclosures relating to bank loans, rent payments and mortgages that the business might have. Another thing to note is how much cash the business has. If the current ratio is low, but most of those current assets are in cash, then that is much better than if a company is cash-poor, and all its current assets are things like accounts receivable and inventory, which might be difficult to convert into cash, especially if there are other problems in the business. For instance, if a retailer has to carry out a sale of its inventory to generate emergency cash, it is unlikely that that inventory will be priced at the same level that it was on the balance sheet.

Disclosure: The author owns no stocks mentioned.

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About the author:

Stepan Lavrouk
Stepan Lavrouk is a financial writer with a background in equity research and macro trading. Specific investing interests include energy, fundamental geoeconomic analysis and biotechnology. He holds a bachelor of science degree from Trinity College Dublin.

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