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How to Check Balance Sheet Red Flags

On July 22, 2016, shares of Boston Beer Company (SAM) soared 15% to $190.16 per share after the maker of leading craft beer brand Samuel Adams reported June quarter results.

Boston reported earnings of $2.06 per share, 12 cents above analystsí forecasts. Further, revenues (sales) for the quarter totaled $261 million, $5 million over analyst expectations. Bostonís share price surge wasnít unusual. The market typically rewards stocks that beat analyst forecasts.

However, that excitement was short-lived. By September 28, Bostonís share price had dropped 21%. Why?

Enthusiastic investors didnít dig into the numbers and overlooked four ďred flagsĒ warning of problems ahead. Two could have been easily plucked from Boston Beerís earnings press release, but the other two required consulting detailed financial statements. In the weeks following the announcement, analysts caught on and their downgrades triggered the ensuing share price drop. Here are the four red flags.

Red Flag #1 Revenues

Boston Beer, a pioneer of the surging craft beer industry, is understandably priced as a growth stock, and growth starts with sales.  Since beer sales are seasonal, itís best to compare June quarter sales to the year-ago number. By that measure, although beating forecasts, revenues (sales) were actually down 3%, so Boston Beer isnít growing.  

Red Flag #2 Gross Margins

Gross margin measures the profit a company makes on a product considering only production costs. A 25% margin means that the company made 25 cents for every dollar of sales before deducting the other costs. Gross margins tell you a lot about a companyís position in its market. Rising margins say a firmís competitive position is improving and vice-versa.

Youíll need a calculator, but gross margin is simply gross profit divided by sales. The June quarter press release listed both. Anyone who did that calculation would have found that the June quarter GM was 48.6% vs. year-ago 52.9%, a red flag warning that Boston Beerís competitive position was deteriorating.

Red Flag #3 Inventories

A firmís balance sheet contains important clues about its fundamental outlook. Boston Beer did not report sufficient detail in its press release, but MarketWatch (www.marketwatch.com) and many other financial sites have the needed information. Using MarketWatch, after entering the Bostonís ticker (SAM), select Financials, and then Quarterly Financials and Balance Sheet. As with sales and margins, always compare the most recent and year-ago quarters to avoid seasonality effects.

Inventories (stock on hand) should more or less track sales. Since Bostonís June quarter sales dropped 7%, youíd expect a similar drop in inventory levels. Instead, inventories rose 7%.

Red Flag #4 Receivables

Accounts receivables are the amounts that Boston Beerís customers owe for products received. Receivables rising faster than sales tells you that customers are taking longer to pay their bills. There could be many reasons, but none are good news. Thus, itís a red flag when receivables grow faster than sales, or in this case, rise when sales drop. Again, comparing the June 2016 and June 2015 quarters, receivables also rose 7%, another red flag.

In the stock market, nothing works all the time. Sometimes youíll detect red flags, but nothing bad happens. Other times, stocks crash without any evident red flags. So consider these red flag checks as another tool for your stock analysis toolbox, not the final answer.

published 10/3/16

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