Avoiding disasters: Tips to protect your portfolio from companies that go bust

Tired of seeing “too big to fail” investments go under? We take a look at how you can spot the signs of trouble before they affect your portfolio.

Corporate failure can have significant consequences for investors. Portfolios can be heavily devalued – or even wiped out completely – if a big player goes under.

So how can you avoid this happening to your portfolio?

The good news is that though investing is inherently risky, there are still steps you can take to protect yourself.

Today, we take a look at some of the main considerations around fundamental analysis on a business, and whether it makes a good fit for your portfolio.

Learning from history

In the early 1900s, philosopher George Santayana famously wrote that “Those who cannot remember the past are condemned to repeat it.”

In 2023, this still applies – especially when it comes to investing.

Seeking advice from long-time and expert investors is a useful way to learn from the mistakes of others, and spot potential problem signs to avoid.

To illustrate the importance of this process, we only need to look at the ASX.

The ASX has a long list of high-profile companies that were “too big to fail” – until they weren’t.

OneTel, Dick Smith, Virgin Australia and many more have become watchwords among investors who remember the flashy public statements and excess – all of which were intended to mask the serious issues beneath.

Now, every company that goes bust does so for a variety of different factors. The market may have changed, a competitor may have emerged with a stronger offering, or poor management may simply be at play.

But investors and the general public often only learn about these issues retroactively – after the damage has been done.

However, there does tend to be a tell-tale sign that can be recognised by outsiders.

Specifically, these companies generally have significant debt obligations – and not enough cash flow to meet loan repayments.
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Identifying financial health

So, how do you identify a company’s financial health?

As with most things in business, it comes down to balance sheets.

Companies with strong cash flow, good cash reserves, manageable debt and which are able to demonstrate consistent profitability are far less likely to run into problems.

They’re less susceptible to the vagaries of rising interest rates, or needing to undertake rounds of capital raising that dilute their offering strength to investors.

Now, there is significant nuance to be applied here. Every company varies in its specific ambitions and goals, so they need to be viewed holistically.

What’s healthy for one company could be quite problematic for another.

The easy example to point to is debt.

Not all company debt is bad by any means. Borrowing is frequently necessary for companies to grow and expand – so debt in isolation shouldn’t necessarily put you off investing in a given company.

You can also get very granular if you want, too. Cash reserves to pay salaries, the level of inventory investment, projected value of IP and much more can all be points to consider.

However, if this sounds like this normally requires a good chunk of financial knowledge and in-depth analysis, you’d be right. Fortunately, there are tools on the market that can help.

Stock Doctor’s research tools enable you to see the financial health of every business on the ASX, rated from “Distress” to “Strong”.

With this information at hand, you’re able to make more informed investing decisions. At a glance, you’re able to spot how much exposure a company is facing via financial risk.

You’re then able to make a call on whether it’s a company that is a good fit for your portfolio, or whether it’s best avoided.

Mitigating the risk to you

Of course, it’s important to remember that all companies have their ups and downs during their life cycle. This is quite normal.

Having access to predictive algorithms can also allow you to take a long-term view.

In conjunction with access to the financial health of the company, you’re able to better decide whether a company’s current situation is just a bump in the road, or a sign of more serious problems.

Remember: those with stronger financial health are much more likely to be able to weather storms and remain viable in the long term.

This doesn’t just apply to making new stock selections, either.

You can also apply these metrics to companies currently within your portfolio and determine whether they’re still appropriate for your current investing goals.

To find out more about trading stocks, make sure you check out our step-by-step guide.

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