Red Flags That May Show Up in Your Business's Financial Statements
Accurate numbers will let you know exactly how well your business is doing. Whether it’s your revenue, profits, debt or cash flow, knowing what healthy accounting looks like for your business is a crucial component for making data-drive business decisions.
To make sure you company stays in the black, keep an eye on these metrics that can signal poor financial health.
High debt-to-equity ratio
While some debt may be necessary to conduct business, you don’t want to take on more debt than your business can handle. If your debt-to-equity ratio is higher than 100 percent, that’s a sign of trouble. The interest coverage ratio is another helpful metric, found by dividing net interest payments by operating earnings. Your finances are in trouble if the ratio is lower than five.
Costly “other” expenses
“Other” is a catchall category for expenses that are irregular or infrequent enough that they don’t justify their own category on your books. “Other” expenses are normal for businesses; however, if these expenses are consistently high values relative to other expenses, or comprise a large amount of your expenses, you may need to rethink your spending. If you spot high “other” expenses, investigate what they were and whether they necessitate changing your budget.
Increasing accounts receivable relative to sales
If you’re waiting for repayment on accounts receivable, that money won’t generate a return. That money has already been allocated in your books, and the longer it goes unpaid the lower your cash on hand.
Too much inventory
You want enough inventory to meet demand, but not so much you’re stuck with unsellable goods. If you’re regularly unable to sell your inventory, you’re taking a loss on money you’ve already spent creating the product, plus any costs to store it.
Unreliable cash flow
Cash flow is meant to do just as it says: flow. Sometimes you’ll have more cash on hand than others. Having a lot of cash sounds like a good problem because customers have paid, but it may indicate you don’t need to spend for new products or services. Too little cash could mean you aren’t charging enough for your work.
Higher liabilities than assets
If your company is assuming more liabilities without a reasonable increase in assets, you may have over-leveraged. Seasonal businesses are especially at-risk, but should be able to plan around changes in revenue.
Lower gross profit margin
Gross profit margin measures a company’s ratio of profits earned versus costs. If that number is declining over time, that’s not a good sign for your company’s profits. The profit margin must be high enough to cover the costs plus any other expenses, like debt.
Declining revenue is an obvious indicator your company is not doing well. Down years will happen, but if revenue declines three years in a row the company is no longer a good investment. Cost-cutting measures can help temporarily, but three years of decline may be a sign to cut your losses.
If you need help deciphering your small business finances, contact our expert financial team at Patin and Associates.