4 warning signs your stocks could be ready to plunge

If these numbers go bad on a company's balance sheet, experts know it's probably time to get out.

By InvestingAnswers Aug 13, 2013 11:56AM
Digital Vision, Digital Vision Ltd.By David Sterman                         

If you regularly shop at department store chain Kohl's (KSS), you may have spotted an unusual merchandising misstep in the spring of 2012.

The retailer, which had built a longstanding reputation for solid designs, good quality and reasonable prices, started to carry less-appealing merchandise that spring. Many shoppers browsed but went home empty-handed.

Just a few months later, you would have seen this problem appear on Kohl's financial statements. In the second quarter of fiscal 2012 (ended July 30), Kohl's unsold inventory of goods stood at $3.5 billion, or 83% of that company's quarterly sales base. Just a year earlier, that percentage stood at 73%.
 
Investors willing to take the time to track this retailer's inventory levels (as a percentage of sales) were the first ones to realize that Kohl's was in trouble. By the time the next quarter's results came out, this balance sheet ratio had swelled to a company record 107%. (What that means is that the company had more inventory than an entire quarter's worth of sales)

When Kohl's owned up to its merchandising problem later that fall, the rest of the investment community followed the lead of these balance sheet watchers and aggressively dumped the stock.



Here are three other important balance sheet metrics you need to watch, so you can get out before the rest of the crowd.

Provision for doubtful accounts
After shipping a product to a customer, a company will often allow for payment terms of 30, 60 or even 90 days. Yet when the due date arrives and the payment doesn't show up, the company will grow understandably nervous. The company's chief financial officer will place that invoice into a balance sheet category known as "provision for doubtful accounts."

As an investor, you want to see how this balance sheet item grows or shrinks every quarter. A rising figure means that one large customer (or several smaller customers) has run into trouble, which means those payments may never get collected, and the customer is less likely to place orders in the future.

This is also a very important item to track amongst banking stocks and credit card issuers. If consumers become delinquent on their loans or credit card payments, then the bank may eventually have to write them off as a loss. Indeed "rising loan-loss reserves" was an early sign of trouble in the U.S. banking industry in late 2007 and early 2008, before events exploded into a full-blown economic crisis.

Underfunded pensions
Over the past few years, investors have marveled at the stunning levels of cash now held by leading automakers. GM (GM), for example, had $34 billion in cash and investments on its books at the end of 2012. Some investors may have mistakenly assumed that such a huge amount of money meant GM could issue huge dividends and stock buybacks while also sharply boosting its spending on new products.

Here's what these investors might not have noticed: Buried further down on the balance sheet, it was clear that GM faced a $37.6 billion gap between the money in its pension plan and the money it will owe its retirees. That's why companies like GM, with underfunded pensions, can't afford to lose money. They need every penny they have to meet pension obligations, and they would go broke if their rapidly aging workforce started to require ever-larger pension outlays. 

If you own shares of a longstanding industrial firm that had a pension plan over many decades, then you need to know the funding status of their pensions.

Too much goodwill
When a company acquires a rival, it often pays more than the target's shareholder equity (or book value). If so, the difference needs to be accounted for as "goodwill" on the balance sheet. Cisco Systems (CSCO), for example, has paid out billions of dollars for many small companies that were little more than a concept and an engineering team, and as a result, now carries $17 billion in goodwill.

Cisco's management believes that these deals will generate solid returns, more than compensating for their lofty purchase prices. But what happens if the acquired companies fail to deliver what had been expected? Cisco would have no choice but to write down goodwill to reflect the failed acquisition.

That's why it's crucial to track goodwill at such companies. If they are spending lots of money on acquisitions but failing to profit from them, then it's a clear sign that management is unable to deliver the long-term growth rates that will keep investors happy.

The Investing Answer: Most investors focus on the income statement to identify potential upside for a stock. Yet it's the balance sheet where you will find early signs of possible share price downside. That's why you should be spending at least as much time on this often-overlooked financial statement.

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6Comments
Aug 13, 2013 10:00PM
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I found this to be a very enlightening and interesting article.  However, over the many years that I have owned individual stocks, received annual reports and proxy statements, I have tried to read the financials.  But I must confess that they are written in accounting jargon that I am not conversant in.  At one point, I thought that I should take a couple accounting courses.  While I understand from the article what to look for, I am not convinced that I would be able to be a good enough detective to find the four things to look for.  I've also found that some companies have a way of burying, hiding information or putting it in obscure places which further compounds the problem of

locating the information that they don't want the uneducated public to find easily.

Aug 13, 2013 2:09PM
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You can't see the handwriting on the wall?

 

"NEW YORK (Reuters) - Stocks erased losses to trade higher by midday on Tuesday after Atlanta Federal Reserve President Dennis Lockhart said economic data remains too mixed to lay out a detailed path for reducing and eventually halting their asset-purchase stimulus plan at their September meeting."

 

That's not causing investing, it's appeasing panic and causing gambling. Count the days... it ends with a BANG (Kool Aid addicts killing themselves).

Aug 13, 2013 2:39PM
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Just like JC Penny, they can clean up the store, make it look nice, widen the isles, but if the merchandise is cheap and the quality is not there or over priced, people notice...and do not buy.
Look at all the constant sales we have now days in the retail stores. That is because most of it is overpriced to begin with and they cannot move it.
Aug 13, 2013 12:58PM
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I hate seeing Goodwill, and other such intangible "assets" on a balance sheet.  For some consumer companies, like McDonald's, their brand recognition has definite value.  For companies like Cisco, that cater mostly to businesses, branding is relatively insignificant.
Aug 14, 2013 7:44AM
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HERE... are two solid reasons to liquidate all your stock positions TODAY. First, the only thing these articles actually say is-- selective data is being used again to create an artificial notion of activity. You can call a Greek and he'll laugh you off the phone for this. SECOND... there hasn't been ONE article chronicling hiring and family-sustaining wage generation in Europe. There isn't any. We have two articles trying to make it look like Central Banks have done some good. They haven't. WORLD MARKETS CRASH SOON because billions are unemployed and there are no economies worth the public's involvement. The Greatest Money Laundering Scam in History is falling apart.

 

LONDON (Reuters) - Clear signs the euro zone has crawled out of an 18-month long recession supported European shares near a 10-week peak on Wednesday and saw German 10-year yields hover near their highest level in almost two months.

The German economy grew by 0.7 percent in the second quarter, its largest expansion in over a year, while the French economy expanded by 0.5 percent, more than twice as fast as expected and exiting its own shallow recession.

The growth in Europe's two largest economies paves the way for a positive surprise when gross domestic product (GDP) data for the whole of 17-nation euro area is released at 0900 GMT (4:00 a.m. EDT).

 

LONDON (AP) - The longest-ever recession to afflict the eurozone came to an end in the second quarter of the year, official figures confirmed Wednesday.

Eurostat, the European Union's statistics office, said the 17 European Union countries that use the euro saw their collective economic output grow by 0.3 percent in the April to June period from the previous quarter.

That's the first quarterly growth since the eurozone slipped into recession in the last three months of 2011. The ensuing recession of six quarters was the longest since the euro currency was launched in 1999.

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