Investors who seek to beat the market should be aware of changes in the financials that signal potential problems. Any shortfalls in the financials spell big trouble for shareholders. While trouble can seems to come out of nowhere, there are early warning signals that can indicate that potential problems. If you are learning to invest, then it pays to perform these simple analyses.

Gross margin is most useful for detecting deteriorating competitive conditions. The gross margin measures the profit a company makes on its products or services it sells before accounting for overhead, marketing, research and development, interest and taxes. When the gross margin rises, it tells you that the company is raising prices and/or reducing production costs. When the gross margins are rising, it is a sign of good future earnings surprises.

Conversely, gross margins that are shrinking indicate that either price raises are not keeping up with cost and/or production costs are increasing faster than revenues. Either condition portends future earnings falls.

The gross margin is calculated by dividing gross operating profit by sales for the same period. Ideally, it pays to compare the gross margin for a company over a series of months. That way you can identify the trend. Moreover, seasonal factors can influence the gross margin, so be sure to include a comparison to the prior year’s numbers.

When a company buys products or services from another, they usually do not pay cash, but instead give their customer time to pay for the goods purchased, say 30, 60 or even 90 days. The amount owed by a customer is called accounts receivables. Normally accounts receivables track sales. If a company sells twice as much as it did a year ago, you should expect its receivables to double.

Sometimes sales grow faster than receivables, indicating that the first is doing a better job of collecting its bills. This is a good thing.

When receivables rise faster than sales, it is a warning sign that there could be trouble. There are three reasons why this could happen:
1. The company is giving its customers longer payment terms to encourage them to order products that they really do not need. This is known as channel stuffing.
2. Customers do not have the cash to pay.
3. The company is slow in billing its customers.

All three are a problem. The first two are harder to fix and will results in sales and earnings shortfalls in the near future. Problem number three can be addressed through more effort to collect the company’s bills. However, it to can be a sign those customers are facing more difficult problems.

When looking at receivables compare the ratio of accounts receivable on the balance sheet to sales on the income statement over time, ideally at least 5 quarters to get a proper trend.

Cash flow is the most reliable measure of a company’s performance, Cash flow measures the movement of cash into and our of the company’s bank accounts during the reporting period. Since cash must be reconciled with actual banks balances, it is a more reliable measure of the company’s results. Reported earnings can be manipulated by management and is subject to arbitrary accounts rules, which can be interrupted differently. You might find some companies report higher earnings, yet they have falling operating cash flow.

Operating cash flow measures the change in bank balances from the operations of the company. Operating cash flow starts with net income and then removes the non-cash accounting entries such as depreciation. When you find a company that is reporting positive net income, yet shows falling operating cash flow it is a red flag.

Relatively simple measures can warn investors of impending trouble. The data for these measures is readily available from the financial sites as well as from the company’s own SEC filings. Taking the time to assess the situation can save you heartache later.

After beginning to invest in high school, Hans Wagner retired at 55, having gained a very good understanding how the indivual investor can succeed. I share that experience with others, so they can achieve financial independence as well. Our model portfolios at http://www.tradingonlinemarkets.com have beat the market every year.

[tags]cash flow,stock market investing,stock analysis,learn to invest[/tags]