Red Flag

What Is a Red Flag?

A red flag is a warning or indicator, suggesting that there is a potential problem or threat with a company's stock, financial statements, or news reports. Red flags might be any undesirable characteristic that stands out to an analyst or investor.

Red flags tend to shift. There are a wide range of methods used to pick stocks and investments, and therefore, various types of red flags. So a red flag for one investor may not be one for another.

How Red Flags Work

The term red flag is a metaphor. It is generally used as a warning or a cause for concern that there is a problem with a certain situation. In business, there might be red flags that caution investors and analysts about the financial future and/or health of a company or stock. Economic red flags often suggest problems approaching for the economy.

There is no universal standard for identifying red flags. The method used to detect problems with an investment opportunity depends on the research methodology an investor, analyst, or economist employs. This might include examining financial statements, economic indicators, or historical data.

Investors need to exercise due diligence when considering whether to make investments in a company or security. Financial statements provide a wealth of data about the health of an organization and can be used to identify potential red flags. However, identifying red flags is nearly impossible on the off chance that the investor can't properly read financial statements. Acquiring a solid understanding of and being able to read financial statements helps ensure success when investing.

Some common red flags that indicate trouble for companies include increasing debt-to-equity (D/E) ratios, consistently decreasing revenues, and fluctuating cash flows. Red flags can be found in the data and in the notes of a financial report. A pending legal claim against the firm, which could compromise future profitability, is one red flag that is often found inside the notes section of a financial statement.

A red flag for one investor may not be one for another.

Problems With Financial Statements

Red flags might appear in the quarterly financial statements compiled by a publicly traded company's chief financial officer (CFO), auditor, or accountant. These red flags might indicate some financial distress or underlying problem inside the company.

Red flags may not be readily apparent on a financial statement, so it might take further research and analysis to identify them. Red flags normally appear consistently in reports for several consecutive quarters, however a good rule of thumb is to examine three years' worth of reports to make an informed investment decision.

Corporate Red Flags

Investors can see revenue trends to determine a company's growth potential. Several consecutive quarters of downward-trending revenue can spell doom for a company.

When a company takes on more debt without adding value to the business, the debt-to-equity ratio could rise above 100%. High debt-to-equity ratios raise red flags for investors. The perception might be that the company isn't performing well and is too hazardous an investment since more creditors finance operations than investors.

Steady cash flows are indicative of a healthy and flourishing company, while large changes in cash flows could signal a company is experiencing trouble. For example, large measures of cash on hand could mean that more accounts are being settled than work received.

Rising accounts receivables and high inventories might mean a company is experiencing difficulty selling its products or services. In the event that not remedied in a timely fashion, investors will question why the company is unable to sell its inventories and what this will mean for profits.

Economic Red Flags

Economists and investors are able to identify signals that the economy is in a difficult situation or is heading toward a downturn. Stock market bubbles might be one indication. This was a precursor to the Great Depression of 1929 and led to the erosion of the savings of millions of people. Bubbles are generally characterized by a rapid increase in asset prices and are deflated after massive sell-offs. This leads to a contraction.

Weaker retail sales may likewise be a red flag for a weakening economy. This indicator accounts for around two-thirds of the American economy, making it a very important consideration. Consumers begin to curb their spending, holding off on purchasing things like furniture, clothing, food, electronics, and appliances. This might be due to higher debt levels, a lack of change in income levels, and even job security. The weaker the retail sales, the weaker the economy becomes.

Highlights

• The method used to detect problems with an investment opportunity depends on the research methodology an investor, analyst, or economist employs.
• A red flag for one investor, however, may not generally be one for another.
• A red flag refers to some warning signal that points to a potential threat, real or perceived — and which warrants further investigation.
• In investing, a red flag is a threat to a company's share price, which can appear on a company's financials, by means of headlines, or through social media.

FAQ

For what reason is it called a "red flag"?

The idiom "red flag" as a warning of danger or some threat, dates back to basically the early 1600s, referring to the use of raising a red flag by a military going to attack. It has since been used in numerous contexts to describe some tendency of trouble or concerns that should be addressed.

What red flags should investors pay special attention to?

There are numerous red flags that can spell trouble for a company, and many are just clear in hindsight. Accounting irregularities or fraud might be detected through careful examination of a company's financial statements and their footnotes, paying special attention to inconsistencies or surprising entries. Auditors are trained to track down and investigate red flags found in a firm's corporate accounting.

What are red flags from financial ratios?

Sometimes, investors or analysts can use financial ratios as a harbinger of bad things to come down the road. A deteriorating profit margin, a developing debt-to-equity ratio, and an increasing P/E may be generally red flags. Note, however, that sometimes a possible red flag might be something ordinary and nothing to worry about.