Financial statements provide important information about a business. Besides monetary conditions, they give insight into a company's future. From time to time, problems may develop. However, catching them early will prevent big headaches down the line. Here are the six most common red flags that may mean trouble is brewing.
It is common for a business to expand its product line, which increases inventory. However, if inventory is going up, but nothing has changed within a company's offerings, it may mean items are not selling. In many industries, the longer a product remains shelved, the bigger the risk it has of becoming obsolete or spoiling.
It is simple to spot this problem by examining the balance sheet. It is important to calculate inventory for the year by using the ending inventory number from the previous year's balance sheet. This amount is divided by the current year's sales. If the number is more than it has been in previous years, something must be done to get products moving at a swifter pace.
Although a large account receivable figure may seem good, it is only profitable if it can be collected. In the business world, the longer an account goes without being paid, the more unlikely it is that your company will see compensation. When receivables begin to mount, it may be necessary to adjust your collections process and become stricter with your credit policies.
Disposal of Fixed Assets
It is acceptable to sell old equipment that is not being utilized or that has stopped performing effectively. However, the proceeds should never be used to pay down debt or be put toward short-term expenses. When this occurs, it may cause problems for the company's future operating expenses. To make sure gains, losses, and disposals are being used correctly, it is wise to examine your income and balance sheets.
Patterns of Poor Cash Flow
Even though a business shows a profit on paper, it may still be cash poor. When cash does not flow into the business, investors may start to worry receivables are not being collected properly, revenue is being exaggerated, or you are struggling to pay your loans. If net cash flow is constantly low, you may suffer a cash crunch. When this happens, it is essential to identify the cause. Many times, it may be due to a slow month or similar circumstances. However, if it is due to poor collections efforts, it is advisable to communicate with your customers and push for payment.
After identifying the root of the crunch, you will have a better understanding of when cash will flow better. It means you may be required to adjust your payment schedule.
It always looks good when your company shows consistent income from continuing operations. Investors are often leery of seeing income from the sale of fixed assets, a large one-time sale, or the sale of investments. Operating income is listed separately from non-operating income on your income statement. If you notice a definite increase from year to year, it may be necessary to target sources of revenue that are solid and steady.
High Number of "Other" Expenses
Many companies have "other" expenses that are very small or inconsistent. It is normal and is reflected in the balance sheet and income statements. However, when these items have high values, it is a definite red flag and needs to be checked. In many cases, some of these expenses can be reclassified. Other times, the high value may be a one-time occurrence.
Delving into your company's financial statements will give great insight into its overall performance and future. Knowing the basic red flags will help you identify problems and solve them efficiently before they become major. In this manner, you will get a true sense of your business's profitability, liquidity, and flow of cash.