Shareholders of companies as diverse as, and have all suffered big losses in recent weeks after those companies reduced forecasts or produced results that fell below the market's expectations.
But that sort of bad news doesn't have to be a surprise to you. Many times, checking a company's earlier quarterly reports for telltale signs that something is amiss will alert you to future problems. Those checks are vital because, in the market, such shortfalls often spell big trouble for shareholders.
Here's how to identify three of those telltale signs, or red flags, that warn of future bad news. You can do the checks using the financial statements on MSN Money. You'll need a calculator, but the calculations are easy. Once you get the hang of it, you'll be able to do the analysis in less than five minutes.
Considering the consequences of not doing the calculations, I'm sure you'll find them well worth the effort.
I'll start with margins, which are useful for detecting deteriorating competitive or operating conditions. Margins are the profit a company makes on its sales. For example, a 25% margin means the company is making 25 cents for every dollar of sales.
Gross margins are a measure of profit before a company accounts for overhead, marketing, research and development, interest and taxes. Rising gross margins tell you a company is reducing production costs or raising prices. Conversely, deteriorating margins say either that production costs are increasing and the company can't raise prices proportionally or that the company is cutting prices in an attempt to maintain market share.
Operating margins are a gauge of profit after a company accounts for overhead, marketing, and research and development. Rising operating margins generally indicate the company is operating more efficiently. However, falling operating margins signal something is amiss. Often, operating margins drop because the company has to increase advertising and other marketing expenses to maintain sales growth.
Margins tend to move in trends. That is, if margins rose in the previous quarter, they will probably be even higher in the current report. That's good news because rising margins usually lead to positive earnings surprises. Margins might fall for innocuous reasons, such as expenses related to a new product's introduction. However, falling margins, either gross or operating, often signal a declining competitive position. Thus it's important to check both.
Calculate gross margins by dividing gross operating profit by sales for the same period. Calculate operating