Red flag

An observation with two plausible explanations, one ordinary and one serious, which the observation alone cannot tell apart.

Example

Receivables growing 52.2% while revenue grows 16.7% - either a large slow-paying customer, or revenue recognised on invoices nobody intends to pay.

Important

It is a reason to slow down, not to stop. What it demands is one named document that would distinguish the two explanations - and what matters most is accumulation, because several flags with one shared explanation are a single large finding.

Related terms

• Deal killer — An established finding that no achievable price can address - because the asset stops being the asset, because the exposure has no floor, or because the counterparty has been shown to be unreliable.
• Days sales outstanding — How long customers take to pay, on average - receivables divided by revenue, times 365.
• Quality of earnings — How reliably reported profit turns into actual cash, most simply measured as operating cash flow divided by net profit.

Lessons that explain it

• Appraising one item: authenticate before you price, not after — Five checks on one specific opportunity, starting with proof the object is genuinely what it claims to be - because a confident price on a fake or misattributed item is not a discount, it is a total loss waiting for a buyer to notice. (13 min)
• Spend the first meeting listening for what is specific — A first meeting is for finding out whether the opportunity fits your thesis and whether the founder's claims are specific enough to check. Structure it, ask for facts, and leave with a clear next step. (11 min)
• Red flags: the signals that mean slow down — A red flag is not a reason to stop. It is a reason to stop moving at the speed you were moving, and to go and find out which of two explanations is the true one. (11 min)
• References you chose tell you more than references you were given — Checking the people behind an investment means verifying claims, speaking to sources they did not nominate, and asking questions specific enough that a vague answer is itself informative. (11 min)
• Messy books are common; hidden liabilities are the real risk — Early companies often have informal accounting. Diligence separates harmless untidiness from problems that matter: unpaid taxes, related-party transactions, commingled spending and unrecorded obligations. (10 min)
• Verify the claims a founder's credibility rests on — Founder background checks confirm the specific facts that make a founder credible for this company - education, roles, prior companies and outcomes - using sources the founder did not provide. (9 min)

All 578 terms in the Investing glossary