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What red flags are there in financial statements that indicate a business is in trouble?
Some well though out answers regarding which financial statement(s) best represent the health of a business. What red flags do you look for when reading financial statements
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4 Answers
My "go to" financial statement of choice, when evaluating a business is the statement of cash flows. Companies, both public and private, can do lots of things to alter net income and returns, but the cash flow statement can provide some telling clues to what to ask, or look for, next from management. I try to review three years' of statements, too so I can get both good trend and fairly robust sensitivity analyses. Changes in the working capital accounts are good trend indicators, and if the company is generating cash from operations consistently, this tells the analyst quite a bit. This statement will surface red flags quickly, too. For example, looking at increasing receivables balances, a use of cash, without corresponding sales increases, can be a red flag for slow collections, more risky terms being granted to keep sales, etc. Cash generated from financing initiatives is also a precursor for evaluating adequate reinvestment in the business for future growth, if warranted.
While not the easiest of the financial statements to analyze, I have found the statement of cash flows generally points to problem areas early and usually surfaces potential watch points in advance of what you might see from simpler ratio analysis.
Financial statements need to be read as a set and there is no one statement that will provide all the answers. As a minimum, all business should produce an income statement and balance sheet, from which a cash flow statement is based.
But there is much more. The accounting system should produce reports of sales by product line, sales by customer, margins by product line and customer, expenses by category, expenses by employee or vendor, payroll and benefits costs and more. Each of these reports will have something to tell about the health of your business. The balance sheet should also have its own reports including AR and AP ageings, inventory reports and other assets and liabilities.
When I review financial statements, I also consider benchmarks including budgets and most important ongoing forecasts that have been adjusted for business conditions. The current operations should always be analyzed against what was expected and variances looked into carefully. If revenues are down, get to the bottom of why. If margins for a particular product line are less than expected, get to the bottom of why and make any needed fixes.
The following is a list, not all inclusive, but indicators that can be monitored for the health of your business:
profit or loss
gain or loss in cash
revenues compared with plan and forecast
growth or decline in inventories
expenses compared to plan
ageing of accounts receivable
ageing of payables
gross profit compared to plan and prior periods
loan balances and borrowing costs
measurements specific to your business, such as commodity costs, trends in interest rates, labor costs etc.
As I have also indicated in many prior posts, having a financial model of your business is also a critical need to control operations. This model will enable you to project financial measurements forward to see if problems that one sees now are going to get better or worse. The model will also give you an indicator of whether the things you thought would fix the problem will actually do so.
Unfortunately, financial statements don't always provide the best picture of immediate financial health. I would want to see subsidiary reports showing a breakdown in cash and find out if any of it is restricted in any way. A receivables aging will tell if there are possible problems collecting and if the figure may possibly be inflated. Are equipment and other assets readily transformed to cash if needed? It is quite possible that a company with an outwardly acceptable balance sheet and revenue/expense statement may be having big problems making their weekly payroll.
In a word, TRENDS. Your banker has a really valuable tool that provides him/her with a trends report for companies by NAICS Code, Revenue Size and Geographic Region. This allows a banker (or in my case, me) to see how your key financial metrics (for Balance Sheet, Income Statement and Cash Flow) measure up against other companies just like yours. That creates red flags as the statements are measured side by side.
Red flags should be discussed to make sure (in some cases they are) that one time instances are identified and that situations that are getting out of control are fixed before it is too late.
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