Red Flags

Flag Risk Recommended Threshold

Falling bad debt allowance Earnings quality Bad allowance as a percent of receivables decreases by
Balance sheet quality 100 basis points compared to prior year and DSOs are >
prior year DSOs

High bad debt allowance Balance sheet quality Bad debt allowance ≥ 10% of gross receivables

Growth in accounts receivables Earnings quality Receivables growth is 15% greater than sales growth and
Balance sheet quality gross dollar receivables growth is at least ¼ of gross
dollar growth in sales

Increasing DSOs Earnings quality LTM DSOs are 15% > prior year and LTM DSOs are >
Balance sheet quality average LTM DSOs for prior year periods

DSOs > industry average Earnings quality DSOs 25% higher than industry average
Balance sheet quality

High provision for bad debts Balance sheet quality Provision > 200% of allowance

Falling deferred revenue and Earnings quality Deferred revenue decrease and revenue increasing
increasing revenue

Rising unbilled revenue Earnings quality Unbilled revenue increase by 5%

Balance sheet quality

Increasing DIOs Earnings quality LTM DIOs are 15% > prior year and LTM DIOs are >
Balance sheet quality average LTM DIOs for prior year periods

LIFO liquidation Earnings quality Gross margins increase and inventories decrease by 10%

Decreasing LIFO reserves Earnings quality LIFO reserves decrease by 20% or debit balance for LIFO
Balance sheet quality reserves

DIOs > industry average Earnings quality DIOs 25% higher than industry average
Balance sheet quality

Rising Finished Goods Earnings quality Finished goods inventories increased by 20%
Inventories Balance sheet quality

Declining forward sales and Earnings quality Analysts’ forward sales estimates decreasing and DIOs
increasing DIOs Balance sheet quality increasing

Serial impairments Earnings quality At least one asset impairment each of last three years

Questionable intangible asset Earnings quality Intangible assets and goodwill >25% of shareholders'
(potential impairment) Balance sheet quality equity and 10% of total assets and free cash flow is
negative

Goodwill and Negative Equity Earnings quality Negative book value, goodwill >10% of assets, losses
(potential impairment) Balance sheet quality LTM and no goodwill impairment
 2

Red Flags
Flag Risk Recommended Threshold
Large Goodwill and Low price- Earnings quality Goodwill >25% of assets, PBV <1, losses LTM and no
book-value ratio (potential Balance sheet quality impairment
impairment)

Extension of asset useful life Earnings quality Asset useful life increases by at least 5 years and
Balance sheet quality depreciation expense 5≥% of operating expenses

Significant restructuring charge Earnings quality Restructuring provisions is ≥5% of operating expenses
“Big bath/Cookie jar”

Serial restructuring Earnings quality Significant restructuring each of last three years
“Big bath/Cookie jar”

Negative free cash flow and Liquidity Free cash flow is less than debt due NTM and current
maturing debt assets - inventories lower than 120% of debt due NTM

Increase in reserve accounts to Earnings quality Increase in reserve accounts >10% representing >2% of
assets “Fill cookie-jar” total assets

Decrease in reserve accounts Earnings quality Decrease in reserve accounts >10%

“Empty cookie-jar”

High pension expected rate of Earnings quality Estimated rate of return on pension asset ≥8.5%
return

High pension discount rate Earnings quality Estimated pension discount rate above 6%

Pension income Earnings quality Net pension income instead of pension expense or large
drop in pension expense

Decreasing stock option Earnings quality Stock option volatility assumption decreases by ≥500
volatility basis points

Decreasing option expected life Earnings quality Option expected life decreases by at least 1.5 years

Questionable deferred tax assets Earnings quality DTAs are ≥5% of total assets and reported losses for past
(potential valuation allowance) Balance sheet quality two years

Low and decreasing tax rate and Earnings quality Tax rate below 25%, decreased over prior year, and
foreign operations (unsustainable low foreign revenues/earnings >20% of total
tax rate) revenue/earnings

Serial acquirers Earnings quality Total acquisition >5% of assets in each of last three years

Large goodwill allocation Earnings quality Goodwill >25% of acquisition price

Balance sheet quality

Rising level 3 assets Balance sheet quality Level 3 assets increased by ≥10% and fair value assets
Earnings quality ≥10% of total assets
 3

Red Flags
Flag Risk Recommended Threshold
Significant level 3 assets Balance sheet quality Level 3 assets are ≥15% of fair value assets and fair value
Earnings quality assets ≥10% of total assets

Low allowance for loan losses Earnings quality Allowance for loan losses as a percent of nonperforming
Balance sheet quality loan is <100%

Loan-loss recovery Earnings quality Loan-loss provision is negative

Balance sheet quality

Significant nonperforming loans Balance sheet quality Nonperforming loans are ≥2% of total loans

Decreasing net interest margin Earnings quality Net interest margin decreased by at least 5 basis points
for two consecutive quarters

Operating cash flow lags net Earnings quality Net income is 1/3 higher than operating cash flow
income Cash flow quality

Earnings expectation Earnings quality Exactly met or beat earnings expectation by one penny
four of last eight quarters

High debt/equity ratio Liquidity Debt/equity ratio > 1.75

Leverage

Low quick ratio Liquidity Quick ratio is less than 0.6

Material cash burn Cash burn Free cash flows are negative, operating cash flows are
Liquidity positive and absolute values of free cash flows are at
least 20% of cash/cash equivalents

Capitalization of operating Earnings quality Free cash flows decrease by 25% and operating cash
expenses Balance sheet quality flows increase by 25%
Cash flow quality

Capitalization of operating Earnings quality Operating margin increase by 200 basis points and
expenses Balance sheet quality capital assets increase by 10%
Cash flow quality

EPS benefit from repurchased Earnings quality EPS benefit from shares repurchased ≥ amount by which
shares company beats earnings estimates

Operating cash flow ratio Cash flow quality Cash flow from operations/current liabilities <1

Large acquisitions Earnings quality Total acquisitions during the LTM had deal values >10%
Balance sheet quality of total assets

Low and falling interest Liquidity Interest coverage ratio below one and decreased year
coverage ratio Leverage over year