Regarding a company’s financial situation, there are danger signs that can be found on the cash flow statement, as well as those already covered on the income statement and balance sheet. Here are the red flags from cash flow.

1) How did the company finance itself during the most recent quarter and year? Did it generate sufficient cash from operating activities, or did it borrow? Although there may be a sound reason for borrowing funds (for example, an acquisition or capital expenditures), any increase in leverage can be a danger sign post global financial crisis.

2) Compare cash flow from operating activities to net income, the starting line. If the company generates an increasing net income but spends itself dry or into the red, that’s not a good sign.

3) Watch for a significant change in the section entitled “Cash from Financing Activities.” This is related to the increased leverage discussed above, but also includes any new shares issued. As new issues dilute the equity of existing stockholders, this automatically lowers the share’s worth.

4) Be wary of capital expenditures, or capex. Economists love it when a company invests in its own future production, which almost always has a trickle-through effect into the rest of the economy (machine orders, construction work done, new hires, etc.), but in reality capex isn’t directly related to share value. If the new factory (for example) is built using borrowed funds or a new share issue, it might not be worth the price.

Other danger signs, however, are less easily spotted. These include:

• A loss of competitive advantage. When the iPod first appeared, Apple naturally rode the product’s success. But as Apple’s competitors brought out their own lines of portable media players, that advantage diminished, lessening the value of AAPL to investors.
• Resignation or replacement of key executives. Some companies are equated with a certain executive or a management team. This is most often the case in technology firms, with names such as Steve Jobs and Bill Gates readily occurring to almost anyone. Other examples include Sir Richard Branson’s Virgin Group, Jeffrey P. Bezos of Amazon.com, News Corporation’s Rupert Murdoch, and Twitter’s Jack Dorsey and Dick Costolo. Unless a strong support team is in place, the resignation or replacement of any such key individual is likely to devalue the company’s shares.
• Low management ownership. If the managers and executives don’t hold at least 10% of a company’s outstanding shares, they’re more likely to take risks or make decisions in their interest rather than the company’s. This is the reason so many executive payment packages include shares rather than cash bonuses: to align the management’s interests with those of the shareholders.

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