Profit warnings, write downs, cash flow: telltale signs investors should sell a stock

Six signs a company in your portfolio could be about to plummet.

No matter what you are investing in, from tracker funds to individual stocks and shares, you need to engage with how your portfolio is performing and establish when it may be time to cut your losses and sell up.

You should not simply stick your cash in a business or fund and then forget it for about five years.

Of course, investing is a long-term pursuit, and just because an investment has had an iffy few months, that doesn’t mean it’s time to sell.

But there are certain warning signs that you should look out for when it comes to individual stocks.

Investment experts Killik & Co have pinpointed six telltale signs that a business may be in trouble, meaning you may want to sell your stock in them.

Profit warnings

The better a business performs, the better the returns for investors.

But if a business is struggling to make a profit, then that should set off alarm bells if you’ve backed them with your own cash.

Firms issue forecasts on how their financial fortunes are looking, and will generally give some notice if their profits are likely to disappoint. 

There has certainly been no shortage of profit warnings of late, unsurprisingly given the turmoil in the economy.

In fact, a whopping 165 profit warnings were issued in the second quarter of the year, with around a third of UK-quoted businesses doing so, according to EY.

A single profit warning is not necessarily a big problem, even though it will tend to rock the share price in the short term.

It’s not uncommon for that price to recover relatively quickly.

The issue comes if the profit warning is not an isolated event, and leads to further warnings down the line, which suggest more fundamental issues at the business.

If the business has issues with profitability, and has a history of missing its estimates in the past, then it may be time to sell.

Upsetting the auditors

When a business publishes its financial statements, it needs to get them signed off by auditors to ensure they are accurate. 

So it’s important to keep an eye out for any signs that the auditors are unhappy, or for any hints that they may consider amending or qualifying a financial report.

That said, just because auditors sign off the accounts, that doesn’t necessarily mean things are legitimate.

The collapse of Wirecard last month was the result of fraudulent book-keeping which hadn’t been picked up by the auditors, while KPMG took an almighty kicking over its failings to adequately check the books of construction firm Carillion when it went bust in 2018.

In other words, while unhappy auditors should definitely be a cause for concern, the fact that a business has been given a clean bill of health by the accountants should not be the be-all and end-all for your investing decisions.

Debt levels

It’s not just individuals in the UK who may be worried about their debt levels ‒ plenty of businesses have taken on stacks of debt too.

With rising interest rates driving up the cost of borrowing, some businesses will find themselves under massive pressure.  

Goodwill write-downs

If business A purchases business B for £1 million, it doesn’t mean that all of business B’s assets are worth £1 million.

The purchase price is generally higher than the sum of those tangible assets, and the difference between them is referred to as ‘goodwill’.

However, there may come a point when the value of that goodwill needs to be reduced, perhaps because of a change in that purchased business’s circumstances.

This sort of write-down may be an admission that the purchasing firm paid over the odds, and could be about to suffer the financial consequences.

One recent example is Micro Focus, a British software business which announced a goodwill writedown of a massive £715 million, having previously bought Hewlett Packard’s software division.

In the last six months, the firm has seen its share price crash from £10.94 a share to £2.87.

If a business you’ve backed reports goodwill write-downs, it may be an early warning sign that there’s trouble ahead and you should consider moving your money elsewhere.

Working capital management

A business’s working capital is the difference between its current assets and its current liabilities.

But it takes proper management to ensure that there is always sufficient cash flow to meet its various short-term costs and debt repayments.

This balancing act, of growing a business and making sales yet still covering the wages, overheads and the rest, is not as easy to maintain as it may appear.

So investors need to keep an eye on the cash flow statements, to monitor how the operating profitability compares with the cash being generated from operations.

As Killik & Co point out: “To uncover this information you might have to get familiar with the basics of a set of financial statements, but for most investors, this is time well spent.”

What about the cash flow?

If a business struggles to maintain a consistent cash flow profile, that’s also a big warning sign. Killik & Co points out that businesses who have gone to the wall in the past, from Enron to Wirecard, have often struggled with this.

Cash flow volatility can be a sign that the business’s management do not really have a proper grip on the core operations of the business, meaning that trouble lies ahead if liquidity dries up.

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The information included in this article does not constitute regulated financial advice. You should seek out independent, professional financial advice before making any investment decision.