Understanding your business’s balance sheet or cash flow statements is essential to operating your business. But staying on top of your business financial statements while running a successful business can be hard when you don’t have the same expertise and clarity as an accountant.
Luckily, spotting red flags in your business financial statements takes a cumulative approach – you don’t need to act on every last red flag as they crop up. However, as your business operations become more complex, it’s crucial that you take an active role in monitoring and updating these records.
This post guides you through six key red flags in your business financial statements that will alert you to problems lurking in your business. Once you know what you’re looking for, these red flags will be easy to spot so you can work with your team or an expert accountant to help you fix any issues.
Monitor for Irregular Cash Flows
Cash flow is one of the most important metrics in your business. Monitoring your cash flow is the easiest part of your financial statement reporting process, as it often uses a simple template.
If your business is generating consistent cash flow, there isn’t much to worry about. However, if your cash flow becomes irregular, you may be facing a financial red flag.
Irregular cash flows can occur for a number of reasons, including paying too much in taxes, mismanaging your accounts receivables, and unexpected expenses. If you notice your cash flow has become irregular over the last few months, you will want to investigate the root cause. The irregularity may be due to a temporary fluctuation (such as an unexpected expense) or a deeper financial problem.
Rising Debt-to-Income Ratio
The debt-to-income ratio is a classic metric indicating how much debt you’re using to finance your business operations. In your first few years of business, monitoring your debt-to-income ratio is crucial to setting a baseline for the rest of your business’s financial life.
If you notice your debt is starting to rise while your income remains stagnant or decreases, you may be facing a critical red flag in your business financial statements. When your debt-to-equity ratio reaches 1:1 (over 100%), your business is considered to be in a debt crisis.
Another way to determine the debt-to-income ratio of your business is by looking at the falling interest coverage ratio. To calculate this ratio, divide net interest payments by your operating earnings. If the ratio is less than five, your business is facing a financial red flag.
There are many free debt-to-income ratio calculators to choose from. Here is a simple calculator provided by Wells Fargo.
Decrease In Revenue Year-Over-Year
Depending on the type of business you operate, you may be facing financial red flags if your notice a decline in revenue over the past three years. If you’re operating a seasonal business, you may want to review your revenue from one year to another to determine whether it has decreased.
If you notice your revenue has decreased, you will want to investigate the cause to determine whether it is due to a temporary fluctuation or a larger problem. You can offset these downturns through several cost-cutting measures, including reducing overhead expenses and cutting payroll-related expenses. However, you should note that these measures can only do so much for the financial health of your business.
If you track three or more years of revenue downturn, it may be too late to make any measurable change to your business financials. Your best option is to seek out accounting experts to help you determine the best next steps.
Rising Accounts Receivable
Accounts receivable is the money you owe your clients. To reduce financial red flags, you want the time it takes to collect these payments to be as low as possible. If you notice your accounts receivable are rising, it could be a sign your clients are having difficulty paying you back on time.
Fortunately, there are several steps you can take to address this problem. First, ensure the terms of your contract are clear. Then, take steps to implement an accounts receivable management software that will automate some of the collection processes.
If these efforts don’t reduce your accounts receivable, you will want to investigate the root cause and determine if the fluctuation is temporary or due to a larger problem.
Higher Liabilities Than Assets
The difference between your assets and liabilities is your business’s net worth. In any business, liabilities and assets fluctuate throughout the year. However, if you notice your business liabilities have exceeded your assets, you should investigate the cause to determine whether it’s due to a temporary fluctuation or a bigger problem.
For example, companies with more cyclical operations (i.e., agriculture, construction, and other season-based companies) may notice their liabilities outweigh their assets a few months per year. This should not be considered a red flag on your business financial statements as it is expected year-over-year.
Decreasing Gross Profit Margin
The gross profit margin on your business financial statements shows the amount of money your business makes after subtracting the cost of goods sold from your total sales. This is an important metric to track as it is easy to understand and helps you determine how much money the business is actually making.
A financial red flag to look out for is a decrease in your business’s gross profit margin. Your business’s gross profit margin accounts for production costs and any additional money needed to cover operating expenses. It’s vital you thoroughly investigate any decreasing gross profit margins on your financial statements to avoid potential financial risks.
There are many red flags indicating potential problems in your business financial statements. If you notice any of these six red flags, you will want to investigate to determine whether they are due to temporary fluctuations in your business or if they point to a much larger problem.
If you find your business is in financial trouble, reach out to Cook CPA Group today. We’ll help you make sense of the issues and guide you through steps you can take to avoid a potential financial disaster.
