Reviewed by Aug 27, 2020| Updated on
A red flag is a warning or an indication that the stock, financial statements, or news reports of a business pose a possible issue or a threat. Red flags can be any undesirable characteristic which makes an analyst or investor stand out.
Red flags can vary. There are many different methods of picking up stocks and assets, and thus many different red flag types. So a red flag concerning one investor might not be the one for another investor.
How Does a Red Flag Work?
The word red flag represents a metaphor. This is usually used as a warning or cause of concern that a particular situation is having a problem. There may be red flags in business which alert investors and analysts about a company or stock's financial future and/or health. Economic red flags also indicate economic issues looming.
There is no universal norm for Red flag recognition. The approach used to identify investment opportunity problems depends upon the analysis methodology employed by an investor, analyst, or economist. This could involve reviewing the financial statements, economic indicators, or historical information.
Rising debt-to-equity (D/E) ratios, steadily declining sales and fluctuating cash flows are some common red flags that suggest trouble for businesses. Red flags can be found in the details and in a financial report's comments. A pending class action litigation against the company, which may jeopardize potential performance, is one red flag that is frequently included in a financial statement's notice segment.
Red flags can appear on the quarterly financial statements prepared by the Chief Financial Officer (CFO), auditor, or accountant of a publicly traded company. These red flags can suggest any underlying financial difficulty or problem within the company.
Red flags cannot be readily apparent on a financial statement so recognizing them can require more study and review. Red flags typically occur continuously for several consecutive quarters in reports so a reasonable rule of thumb is to review reports worth three years to make an educated investment decision.