How to spot the danger signs in company accounts

No one not even the Government is trying to deny that Britain is heading for a nasty recession next year. That will mean a "catastrophic" rise in the number of firms going bust, reckons R3, the leading professional insolvency association. President Nick O'Reilly says "we will approach the numbers we saw at the peak of the last recession in 1992". That may even be optimistic.

So how can investors make sure they avoid buying shares in bankruptcy candidates? A weak credit rating below BBB- or 'investment grade', using Standard and Poors criteria is a starting point. But as one German investor put it in The Guardian, so far these ratings "have not been good predictors of defaults". For example, US insurance giant AIG was rated AA shortly before requiring a $150bn US bailout.

So what else should you be looking out for?

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Are the auditors happy?

Every British firm must get its accounts signed off by auditors each year. If you have never read an audit report, it's time to start. It's a single page, usually buried in the middle of the accounts, just before the income statement (or 'profit and loss account'). The key bit, the 'opinion', normally just confirms that the auditors believe the accounts are 'true' (accurate) and 'fair' (reasonably unbiased).

But maybe not this year. Accountancy firm Deloittes has predicted that as many as 5% of all listed companies "are unsure if their business will be able to continue for the next 12 months", says Accountancy Age. These will have a warning paragraph headed "going concern emphasis of matter" in their audit reports. Indeed, BDO Stoy Hayward partner Graham Clayworth expects the use of such warnings to increase, thanks to banks not renewing overdraft facilities and a "heightened risk of companies failing due to counterparty risk".

Is a profit warning ahead?

"European companies are set to issue a wave of profit warnings over the coming months," says the FT's Richard Milne. So how can you spot the vulnerable ones before you buy their shares?

First, check sales. Compare the latest quarterly or six-month growth rate to the last five years (listed firms produce a five-year summary). No one expects great growth just now, but a 50% drop or more on trend is a red flag, says Harry Domash on MSN Money.

Next, check for falling profitability using the operating profit margin (profit before interest and tax divided by sales). If this falls by 20% or more in a year, watch out. For example, a UK food retailer might have an operating profit margin of 5%. A drop to 4% or lower indicates trouble.

Also watch interest cover profit before interest and tax, divided by the interest charge (just below it). Ideally you would also check this using the cash flow statement by taking 'operating cash flow' and dividing by 'interest paid'. If cover has fallen by 50% or more say last year it was six times and now it's just four it suggests the firm is struggling to cover financing costs. Cover below two on either measure screams 'get out'.

Is the balance sheet unbalanced?

Troubled companies often lose control of 'working capital' or 'net current assets' on a balance sheet. Receivables, or 'debtors', should move with sales. If sales are falling and receivables don't keep pace (look for a change in the ratio of receivables to sales of more than 20%), it may mean that customers are delaying payment. Earnings and cash flow will both be hit soon afterwards.

It's the same with stock or 'inventory'. Watch for stocks rising faster than 'cost of sales'. Again, an unexplained rise of more than 20% in average inventory over 'cost of sales' is a bad sign. Often it flags poor stock management the firm is keeping stuff that customers simply don't want. That too will soon eat into cash.

Finally keep an eye on 'fixed' (long-term) assets via the 'fixed assets note'. Look for evidence of regular write-offs, or 'impairments'. As anyone who has invested in banks knows, once these start appearing, they often continue. The risk increases hugely if assets think the RBS acquisition of ABN for example were bought in the last few years at the top of the market. Previously acquisitive firms are likely to take the biggest hits.

Check for 'hidden' risks

You can identify a firm's known liabilities (such as amounts due to suppliers, banks and the tax office) by looking at balance sheet 'creditors'. But other obligations may be hidden. Check the 'contingent liabilities' note toward the back of the accounts. If there is a legal case hanging over a company, an unresolved customer dispute, or any situation that might result in a pay-out, it'll be here. Recessions breed litigation the fall of Lehman Brothers could make $900m for lawyers, says the FT and this note often flags it.

What to avoid

Small cap and Aim stocks are the most vulnerable and we'd avoid them for now. For example, last month, for the first time in ten years, the Aim market failed to raise any new funds, says the FT. Alistair Darling may be trying to ease the pressure on small firms, but the going is so tough institutional investors are questioning whether these firms will return to favour even in the medium term.