A company’s financials are the most objective way to assess the health of an organisation. As the old adage says, “numbers don’t lie.” Numbers can indicate prosperity or poverty, but they can also show the first signs of trouble within a company. To help you recognise what the numbers are trying to tell you, we’ll explore eight identifiable red flags that can serve as indicators of trouble to you or anyone else reviewing your financials.
How to Read a Financial Statement
Before you can identify trouble areas, you first need to understand how to read a financial statement. Many people simply open it and look for the top-line assessment, revenue profit or loss, income statement and cash flow. There are other areas, however, that you should be aware of.
Primarily, financial statements are broken down into four key areas:
- Auditor’s Report: This is a statement prepared by the statement’s auditors that outlines top-line trends and opinions based on the auditors’ findings.
- Financial Statement: The statement itself is actually a collection of reports that provide a picture of an organisation’s cash flows and financial condition. The reports typically included in a financial statement are the balance sheet, income statement and the statement of cash flows.
- Notes to the Financial Statement: A veritable “cheat sheet” of the company’s accounting practices or intricacies to aid in reading the document. It can also include explanations for any odd entries or items.
- Management’s Discussion and Analysis: Similar to an executive summary, this is a note from management that includes any information or topics that management would like to communicate to its shareholders or the readers of the report. This information is often inferred in parts of the report, and is called out in this section because it may not necessarily be obvious to the reader.
These sections provide valuable information that will help you determine the company’s profitability, liquidity, and cash flow; all important figures when determining health.
Red Flags to Look For
Now that you have an idea of how to read financial statements, here are eight red flags that can indicate trouble for a business.
- Rising debt-to-equity ratio: This indicates that the company is absorbing more debt than it can handle. A red flag should be raised if the debt-to-equity ratio is over 100%. You can also take a look at the falling interest coverage ratio, which is calculated by dividing net interest payments by operating earnings. If the ratio is less than five, there is cause for concern.
- Several years of revenue trending down: If a company has three or more years of declining revenues, it is probably not a good investment. While cost-cutting measures—such as wasteful spending and reduction in headcount—can help to offset a revenue downturn, it probably won’t if the company has not rebounded in three years.
- Large “other” expenses on the balance sheet: Many organizations have “other expenses” that are inconsistent or too small to really quantify, which is normal across income statements and balance sheets. If these “other” line items have high values, then you should find out what they are specifically, if you can. You’ll also want to know if these expenses are likely to recur.
- Unsteady cash flow: Cash flow is a good sign of a healthy organisation but it should be a flow, back and forth, up and down. A stockpile of cash can indicate that accounts are being settled, but there isn’t much new work coming in. Conversely, a shortage of cash could be indicative of under-billing for work by the company.
- Rising accounts receivable or inventory in relation to sales: Money that is tied up in accounts receivable or has already been used to produce inventory is money that cannot generate a return. While it’s important to have enough inventory to fulfill orders, a company doesn’t want to have a significant portion of its revenue sitting unsold in a warehouse.
- Rising outstanding share count: The more shares that are available for purchase in the stock market, the more diluted shareholders’ stake in the company becomes. If a company’s share count is rising by two or three percent per year, this indicates they are selling more shares and diluting the organisation’s value.
- Consistently higher liabilities than assets: Some organisations experience a steady stream of assets and liabilities as their business does not hinge on seasonal shifts or is less affected by market pressure. For companies that are more cyclical (i.e. construction companies during the winter months), however, it’s possible that its liabilities will outweigh its assets. Technically, this should be something the company can plan around, thereby decreasing the discrepancy. If a company is consistently assuming more liability without a proportionate increase in assets, however, it could be a sign it is over-leveraged.
- Decreasing gross profit margin: As this measures a company’s ratio of profits earned to costs over a set period of time, a declining profit margin is cause for alarm. The profit margin must account not only for the costs to produce the product or service, but the additional money needed to cover operating expenses, such as costs of debt.
Analysing a company’s financial statements, whether you own shares or might invest in it later, is a valuable skill. Take the time to really delve into financial reports and see what types of red flags you identify. Being able to understand the intricacies of a company’s finances is just one more way to ensure success.