5 Red Flags To Look Out For Before Investing in a Company
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Becoming an investor means making choices. You have to develop an overall strategy to build and diversify your portfolio, and you must consider your risk tolerance. With so much information available, it’s easy to get overwhelmed and miss clear red flags that a stock might not be a wise purchase.
Elizabeth MacDonald, financial journalist and host of Fox Business’ “The Evening Edit,” has spent decades uncovering corporate accounting scandals, exposing hidden risks, and warning investors about trouble before it hits.
“I must warn you,” she said, “this is industrial-strength uber geekiness. But once you start, it’s pretty easy to do.”
Here are the top warning signs she says you should look for before you buy.
Red Flag No. 1: Weak or Inconsistent Financial Performance
Before you invest a single cent, make sure the company is financially sound.
“You’ll want to examine key financial, operational, and strategic indicators,” MacDonald said. “The easiest way is to go to the company’s financial statements, which you can find on the SEC’s website, and compare their recent financial performance to prior years.”
Investors should ask themselves basic questions about a company’s financial performance: Is revenue growing year to year? Is the company consistently profitable? Are gross, operating, and net margins stable or improving? Overlooking these measures can cause trouble down the line.
Ask whether the company has more assets than liabilities. What is the debt-to-equity ratio? How healthy are the cash reserves? If you can’t answer these questions, you could be running through red flags like a bull.
Red Flag No. 2: Risk Disclosures That Signal Trouble Ahead
MacDonald always reads the risk disclosures in SEC filings first — and says they can be surprisingly revealing.
“The company’s risk disclosures are a go-to for any investor — they talk about the risks the company faces, plus a company’s management track record,” she said.
These sections can disclose issues ranging from pending lawsuits and regulatory investigations to supply chain vulnerabilities, labor disputes, reliance on a single major customer, or exposure to volatile commodity prices. Ignoring risk disclosures could mean missing early warnings about challenges that may threaten the company’s stability.
Red Flag No. 3: Weak Balance-Sheet Ratios
Numbers buried in the balance sheet can tell you if a company is headed for trouble long before the headlines do.
“Current assets versus current liabilities can highlight red flags about a company’s liquidity problems,” MacDonald explained. “Return on equity (ROE) measures how efficiently the company uses shareholder capital — higher is better. Earnings per share should be positive and ideally growing.”
A price-to-earnings ratio that’s far above industry peers may mean the stock is overvalued and due for a correction.
Red Flag No. 4: Management That Doesn’t Deliver for Shareholders
Even profitable companies can be poor investments if leadership isn’t positioning the business to create long-term value.
“Look at whether management has built shareholder value over time,” MacDonald said. “Are they making smart capital allocation decisions, or are they burning cash on questionable acquisitions and buybacks? History matters.”
If leadership has a pattern of missing guidance, issuing frequent restatements or changing strategy without results, proceed with caution.
Red Flag No. 5: No Competitive Edge in a Changing Market
A company without a demonstrable competitive advantage can lose ground quickly.
“Is the company adapting to changes in its industry? Does it have pricing power, brand loyalty or cost advantages?” MacDonald asked. “Is it holding steady or growing its market share?”
If the answers are no, the business may not be able to maintain margins or protect its market position over the long term.
Bottom Line
Investing requires making choices, sometimes tricky ones. But if you know where to look — financial statements, risk disclosures and core ratios — you can spot many red flags before they cost you.
This article is part of GOBankingRates’ Top 100 Money Experts series, where we spotlight expert answers to the biggest financial questions Americans are asking. Have a question of your own? Share it on our hub — and you’ll be entered for a chance to win $500.
This article is for informational purposes only and does not constitute financial advice. Investing involves risk, including the possible loss of principal. Always consider your individual circumstances and consult with a qualified financial advisor before making investment decisions.
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