What are Yellow Flags

Yellow flags are danger signals warning of long-term problems, but not necessarily in the next quarter.

Capital Expenditures

Depreciation accounts for the deterioration and obsolescence of buildings and capital equipment. To remain viable, a company must be continuously upgrading and replacing its aging equipment. You can tell if that’s happening by comparing the depreciation credit in the operating cash flows section to the capital equipment expenditures listed in the investing section of the cash flow statement. At a minimum, capital expenditures should equal the depreciation charge, and ideally capital expenditures should exceed depreciation.

Income Tax Rates

The income before taxes entry on a corporation’s income statement reflects what the firm’s profits would be if it paid no income taxes. Then the company subtracts income taxes to compute the bottom line net income. It’s the net income that’s divided by the number of outstanding shares to determine the make-or-break earnings per share.

Most corporations pay income taxes in the range of 35 percent to 40 percent of before-tax earnings. Of course, since the goal of individuals and corporations alike is to minimize taxes, the rate can vary widely. Let’s consider a hypothetical example to illustrate the significance of income taxes on reported earnings. Assume that a company earned $1,000 before taxes and has 1,000 shares outstanding.

It’s clear that the tax rate has a huge impact on EPS, and even a small change can mean the difference between a positive or negative earnings surprise.

Low tax rates are great as long as they stay low. If a company reports losses, it can apply its losses to future profits, thereby paying reduced taxes until its loss carry-forwards are depleted. The problem arises when they are used up, and then the reversion to the normal tax rate unexpectedly reduces earnings.

Some companies always pay lower taxes because of conditions particular to the company and/or its industry. The best way to get a handle on a company’s income tax situation is to compare its current and historical rates. You can calculate the income tax rate by dividing the income tax by the before tax income, but it’s easier to look it up on MSN Money.