by Michael Lodge
In several of my business and tax blogs I have tried to tell you that as business people and investors, you need to understand how to read financial statements. The income statement is the score card of any business and it tells a story. So you need to know what your income statement and balance sheet is telling you. Today we are going to talk about “Red Flags” in a financial statement and what to look out for.
Financial analysts and CPAs have the uncanny ability to identify worrying trends after only a cursory glance at a set of financial statements. You can do the same thing if you know what red flags to look for. To fully analyze your financials, you need a copy of your balance sheet, income statement, and cash flow statement. Obtain these financial statements from the last two or three years to track year-over-year trends.
Here are five big warning signs to watch out for:
If you’re expanding your offerings, a higher inventory balance may be warranted. However, if inventory is increasing, it may also mean your products aren’t selling — and the longer they sit on your shelf, the higher the risk is of obsolescence or spoilage.
How to spot it: Calculate average inventory for the year, using the ending inventory figure from last year’s balance sheet as the beginning balance for this year. Divide average inventory by this year’s sales. If this percentage is higher than it is for prior years, you may have some inventory on your books you simply can’t sell.
A high accounts receivable figure is a good thing — if you’re sure you can collect it. However, the farther past due an account becomes, the less likely it is the customer will pay down the balance. A growing receivables account could indicate you’re not being effective at collecting what you’re owed.
How to spot it: Divide the average accounts receivable balance by annual sales. If the ratio is higher than it’s been in previous years, receivables are building up. For further investigation, run an aging schedule in your accounting software that categorizes receivables balances by due date. If most of the receivables are past due, put more effort into collections or look into factoring your receivables.
Disposal of Fixed Assets
It’s okay to sell equipment that’s not performing well or is now unnecessary for operations. The problem is some business owners dispose of fixed assets and use the cash for short-term expenses or to pay down debt. Unless proceeds from fixed assets are reinvested into the business, fixed asset disposals can hamper future operating revenue.
How to spot it: Gains and losses from fixed assets are noted on your income statement and disposals are apparent on the balance sheet. As the business owner, you know why you sold the fixed assets. If disposals are significant, prepare an explanation of your reasoning for the sale and what you intend to do with the cash proceeds.
Poor Cash Flow Patterns
Some companies have great profit on paper but are still cash poor. If cash isn’t flowing into the business, investors may be concerned you aren’t collecting receivables quickly enough, are struggling with loan repayments, or are exaggerating your revenues.
How to spot it: There will be some difference but net cash should generally track net income. If net cash flow is low year-over-year compared to net income, you could be headed for a cash crunch.
Investors and creditors love to see consistent income from continuing operations. They’re more wary of income from other sources, like large, one-off sales, gains from the sale of fixed assets, and gains from the sale of investments. These non-operating revenues aren’t as valuable because there’s a strong possibility this revenue won’t reoccur.
How to spot it: Non-operating income is easy to identify because it’s stated separately from operating income on the income statement. Analyze the relative proportion of operating income to non-operating income year-over-year. If it’s decreasing, you may need to refocus your efforts into revenue sources that won’t disappear.
If you have questions on financial statements, bookkeeping, tax issues, call our office at 877.778.1770