Financial statements are a good way to know how well your business is doing. These important reports enable your team to identify issues that need to be addressed to put your business on the growth path.

In order to do this, you need to look for certain ‘red flags’ in your financial statements. These would serve as warning signs which you might need to address quickly to secure your business from possible trouble. Examine your balance sheet, income statement and cash flow statement for performing this analysis. These should span the last two or three years so that you can identify year on year numbers.

The following are some of the warnings signs in financial statements that might need your attention.

Urgent Warning Signs in Financial Statements 

Excess or Insufficient Inventory :

If your business is based on a product rather than a service, you need to take careful stock of your inventory. A higher inventory is permissible only if your business is on the expansion mode. However, if you find your inventory is increasing when you are not expanding, it could mean that your products are not selling or that your customers are dissatisfied with the product and are returning them after purchase. Whatever be the case, excess inventory would result in your products getting obsolete or not suitable for use. Add to this the fact that it costs money to store inventory and insure them.

In addition to excess inventory, insufficient inventory is also a warning sign. Insufficient inventory would lead to loss of sales and increased costs. If you run out of crucial raw materials, then your operating costs would go up. You might have to pay overtime to employees if raw materials come in late. In the worst possible situations, you could end up buying inventory at high prices.

How to spot:

First, identify your average inventory for the previous two years. To do this, add the beginning inventory balance to the ending inventory balance. For instance, if your company began the year with $500,000 of inventory and finished with $480,000 of inventory, total the two to get $980,000. If you divide this figure by two, you would get the average inventory. In this example, divide $980,000 by two to get $490,000 as the average inventory. You could use the ending inventory from previous year’s balance sheet as the starting inventory for the current year. After this, divide average inventory by the year’s sales. Compare this percentage over the years to see if your inventory is increasing or decreasing.

High Number of Accounts Receivable Days:

You might think that having a large accounts receivable figure is good. It might be, depending on how quickly you can convert it to cash. However, it is far from easy to quickly collect money from your customers. Understand that the further away your receivable is, the more likely it is that it might become a default. So, actually, a growing receivables account could reveal that you are not being effective at collecting what others owe you.

In this regard, the accounts receivable (AR) days can alert you if you are not receiving payments from customers quickly enough. Generally, a lower figure for AR days is beneficial, because it means you are getting cash quickly. Though, this can vary from firm to firm, data from Sage works says that for all industries, the average AR days is 39. A comparison over the years and with competitors will give you an idea whether you are able to manage AR well.

How to spot:

To arrive at the AR days figure, you need to divide accounts receivable by sales (annual revenue) and then multiply it by 365 days. Do it for at least three or four years. If you find that this figure is higher than it has been in previous years, you can be sure that your receivables are piling up and you need to do something about it.

If you want to investigate further, you could run an aging schedule as part of your accounting software. This schedule will help categorize AR balances by due date. If a large number of ARs are due, you might need to look at speeding up collection or change collection terms. Also, note if the same customers repeatedly show up as past due in the aging schedule. If this is the case, you might need to re-evaluate whether you should continue doing business with them. Other indicators include accounts receivable turnover, credit policies and cash collection schedules.

Increasing Non-Operating Income:

Selling equipment whose performance is not up to the mark or that is not needed for operations anymore is normal routine for any business. However, selling fixed assets every now and then could mean that your business is trying to raise cash to meet short term expenses or pay off debt. Unless the money from such sale is reinvested in the business, your operating revenue might be impacted in the long term. Some businesses might get income from other one-off sources, such as money from sale of investments. These are non-operating revenues and they are not as valuable because there is no guarantee of getting income from the same sources in future.

How to spot:

Check your income statement for gains and losses from fixed assets. Disposals might also be apparent on your balance sheet. You will know why the assets were sold in the first place, so if the disposals are significant, list down why you sold them and what you used the cash for. If the reasons are to meet short term crunches, then the next step would be to analyze the reason for the shortfall, such as long AR days cycle. Also, check the non-operating income that is stated separately from operating income on your income statement. Compare the proportion of operating income to non-operating income over the preceding years. If this is decreasing, you might have to focus on generating better revenues from your core operations.

Cash Flow Problems:

Having good profits is not an indication that your business is doing well. Only if you manage your cash flows well, can you grow in the long term. If profits are good but cash flows are not, it could be that you are not collecting receivables quickly enough or you are struggling with repayment of your loans, or even worse, you are exaggerating your revenues. A financially well-run business should have an improving cash position at the end of every month rather than every year. It is important to check your cash flow position month on month, at the end of every quarter to quickly spot and rectify problems.

How to spot: 

The general rule is that your net cash should match your net income with little difference. If you find that your net cash flow is low compared to the net income, you can be sure that you are in a cash crisis. You must look at a three-month projection as cash disappears quickly and unless swiftly rectified, things might go out of the hand. For instance, if your sales have increased 10%, but your cash flows are rapidly declining, you might be collecting accounts receivable later than required. If it is the other way round, with cash flows increasing and sales declining, a different problem arises. This could mean that you are not marketing your products well.

The quicker you identify the problems in your business, the lower would be subsequent losses. Losses not only mean money, they also include time and resources that could have been used productively. So, pro activeness in dealing with warning signs in financial statements is crucial for the growth of your business.

Credit: Senthil Kumaran, Operations Manager – Finance and Accounting, Invensis Technologies

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