History shows that in the long term, the performance of a stock is directly related to the financial performance of the business. If a business does well, stocks eventually follow.
Every business starts small, and slowly becomes big because of its able and experienced management, prudent asset allocation, good marketing and branding efforts and finally, continuous innovation based on the changing trends in the market.
While it is easier to grow in the initial stages, the real challenge begins when company grows big in size, known as the S-curve.
Every business goes through three stages, the initial, low growth phase, a stage where business requires time and effort but does not generate much profits, since it’s a new business and does not have large customer base to make it profitable.
Second stage is the high growth phase, where company shows huge growth, the profit margins are high and customer base expands rapidly, this is also called the golden phase of the business where it generates lot of capital for its shareholders.
The final stage is the saturation phase, where the company becomes so big, it finds difficult to sustain its growth, and thus starts saturating.
It is easier for smaller sized companies to grow rapidly compared to large sized companies because of smaller capital base.
For example, A company that is Rs.100 crores in size can easily find a revenue source that will add another Rs.100 crores to its Net Worth, thus doubling its business value. But for a company that has a Net Worth of Rs.1,00,000 crores may find it difficult to generate a revenue source of Rs. 1,00,000 crores.
As the companies grow in size they find it difficult to sustain their profitability and growth, and thus start experiencing a decline.
One of the strongest examples can be found in an article written in the Newspaper, The Hindu, which shows that out of 30 companies listed in Sensex in 1992, only 7 have successfully maintained their growth.
Thus, as investors, it is important to keep tracking the growth of companies you have invested in,and if there are signs of a decline, it is better to exit that stock.
But the question is, how do you know if a company has started to decline and it is no longer a business worth staying invested in?
In this post of 5 signs that show a company is declining, we are going to talk about 5 clear signs that you can study from the financial statements of the company, which shows you that the company may be declining.
5 Signs That Show a Company is Declining:
Evaluating signs whether the company is really declining requires more, in-depth analysis of financial statements.
However, there are some preliminary, easy to spot signs that give you a decent idea if the financial performance of the company is deteriorating financially.
One of the first and the most obvious signs that show a company is declining is decline in revenues or sales of a company.
Every company needs to sell some products or service in order to make profits. This is the reason why it’s called the top line of the company, as it is the source for all the money that flows into the organization.
Decline in revenue is the first red flag of deteriorating fundamentals and shows that the company is struggling to generate sales, making it difficult for the business to stay afloat.
Even a flat revenue for a long period of time is a warning sign for a business. If you can find that revenue of the competitors is growing over the same period, it is an even stronger sign of poor management and deteriorating health of the company.
For example, here is a screenshot of financial performance of BHEL(Bharat Heavy Electricals Limited), where you can easily see the declining revenue over the past several years.
On March 2012, the Total Revenue generated by BHEL was Rs. 47,964 crores, while on March 2018, the revenue declined to Rs. 28.962 crores, a 40% decline in revenue.
As a result, the stock price of BHEL declined from Rs.152 in Jan 2012, to Rs.70 per share in 2018, a decline of 54%.
Declining/Negative Net Profit Margins
The second most significant sign that show a company is declining in its fundamentals is decline in Net Profit Margins.
Net Profit margin is calculated by dividing total Net Profit by total sales, and indicates how much profit a company is making behind each sales made.
For example, if a company’s sales is Rs. 100 and its Net Profit is Rs. 20, the Net Profit Margin of the Company is 20/100=20%.
Companies with higher profit margins indicate that they have pricing power on their product and people are willing to pay a premium price for its products and service.
A declining profit margin shows that company is generating less profit for each sales made, leading to decline in profits, leaving very little in the hands of business.
A negative profit margin on the other hand shows that company is unable to generate profits from its sales and is suffering losses.
A consistently declining or negative profit margins for longer period of time is a sure shot warning sign for investors that show a company is deteriorating fundamentally.
The third sign that show a company is declining or deteriorating its health is rising debt. Every company needs funds to expand its business.
There are only two ways companies can raise capital to fund their expansion, first is equity where companies approach investors and offer part ownership in their business in exchange of capital funding. Funding business via equity is a long and cumbersome process.
The second way (and an easier one) is to borrow capital as loan from lenders such as banks.
But why is rising debt a sign of deterioration? When a company takes a loan, it has to pay a fixed interest to its lender on regular basis(monthly, quarterly, annually etc based on the contractual agreement between borrower and lender). When a company takes way too much loan, it has to pay a large part of its profits as interest, leaving very little profit in the hands of the company and its shareholders, which means that company may not be able to grow despite making healthy profits.
Secondly, if the profits of the company decline,or if the company suffers a loss for some reason, it still has to pay those interest, which means that company either has to sell its assets to meet the obligations or file for bankruptcy.
A very apt example of how huge borrowing can destroy a company can be seen by studying the infamous case of Kingfisher Airlines.
Kingfisher Airlines was started in 2005, and was struggling to make profits since its inception. In order to keep funding its operating expenses, despite losses, Kingfisher Airlines started borrowing capital from banks and other lenders, further burdening its balance sheets. Despite decent revenue growth, Kingfisher Airlines was suffering losses because of huge finance costs.
From 2009 to 2011-12, Kingfisher Airlines had earned decent revenue growth, from Rs.5,269.17 crores in 2009, to Rs.5,493 crores in 2012.
Despite revenue growth, Kingfisher Airlines suffered operating loss of Rs.1,917 crores in 2009, to Rs.3,466 crores in 2012, which was largely contributed by huge finance cost which soared from Rs.696 crores in 2009, to Rs.1,276 crores in 2012.
Kingfisher is a classic case of how huge debt can bring a business to its knees despite revenue growth. As investors, you should always be vigilant of rising debt.
If the company’s earning are improving faster than its finance cost, it shows that company is utilizing its borrowing efficiently, but on the other hand, if the finance cost is escalating without much improvement in earnings, it is better to exit the stock.
Declining ROE and ROCE:
The fourth sign that show a company is declining is the decline in ROE and ROCE ratios.
Every company tries to manage their resources in the most efficient way possible, so that they can get maximum returns by utilizing minimum resources.
ROE and ROCE stands for Return on Equity and Return on capital Employed, respectively,
Both the financial ratios measure the capital efficiency of a business, that is, how much returns a company is generating for each rupee of capital used in the business.
While ROE measure return a company generates on total equity, ROCE measure return on total capital employed, that is equity and debt.
In other words, ROCE is a more conservative measure of capital efficiency of a company.
A declining ROE or ROCE shows that company is unable to utilize its financial resources efficiently, or investments made by the business are not generating cash.
So, how much of ROCE is good? Well, the answer varies from industry to industry.
Large capital intensive businesses, such as Infrastructure, Iron and Steel manufacturing companies have lower ROCE compared to companies working in sectors with low capital requirement such as FMCG,
As a thumb rule, the ROCE of a company should be higher than company’s cost of borrowing, otherwise any increase in borrowing cost would reduce shareholders earnings.
Declining ROCE does not have a direct impact on the performance of a stock, but it definitely is an important performance indicator for a company.
If a company’s capital efficiency continues to decline for a longer period of time, it has to borrow additional capital to maintain its profits, which means that company is burning more cash while generating lesser returns.
Declining Free Cash Flow:
Last, but the most important and reliable sign that show a company is deteriorating is declining free cash flow.
Free cash flow is the cash left with the company after paying for all the capital expenditures. One of the primary reasons why Free Cash Flow is considered to be the most reliable metric is that it is hard to manipulate cash transactions.
Analyzing free cash flows can reveal hidden secrets behind the business that no other financial metric can.
How? Many companies sell products to their clients on credit, which means they register a sale on their books, but receive cash later.
If a company is selling most of its products on credit, it generates lot of sales, but receives very little actual cash, giving a false impression that company is profitable.
If the customer refuses to pay for some reason or if the payment is delayed for longer period of time, the company may face cash crunch, which means company will not have enough capital to fund its operating expenses, leading to decline in sales and, in some cases, even bankruptcy.
It is thus important to look at cash flow statements of the company, calculate free cash flow, and compare it with the sales and profit numbers to understand how efficiently a company is able to turn its sales into actual cash.
A company with high sales to free cash flow is always a preferred investment.
Before we reach the conclusion, here is a sum of all the points we have covered in this article in a simple info graphic:
Companies, whether big or small, can always experience decline in their growth and quality of earnings, and that is why, it is important to keep tracking the financial performance of the companies you are invested in.
In general, flat to declining sales revenue, lower profit margins, and most importantly, declining or negative free cash flows are warning signs that show a company is deteriorating.
If the management of the company takes the steps in the right direction, there is always a chance of turnaround, absence of such prudent and intelligent decision making may lead to further decline in price of the share, ultimately destroying shareholders wealth.
That is a wrap on this post of signs that show a company is declining. I hope you found this article useful and knowledgeable.