Oct 14, 2020

Spotting Red Flags in Your Financial Statements

Financial statements are meant to provide insight into your business and help you to make informed, strategic decisions. With the data you collect and report, you can identify a host of problems, ranging from wasted spending to underperforming investments. 

However, a financial statement is only as good as the insight you can glean from it. If you aren’t sure how to read the reports, don’t update them regularly, or don’t take action on them, they won’t be valuable. 

If you’re new to financial reporting or have a hard time knowing what to look for, consider these 5 red flags in your financial statements.

1. A High Debt-to-Income Ratio

Business and personal accounting have 1 thing in common: you always want to make more than you spend. If your debt-to-equity ratio is on the rise, then you’re spending more than you’re bringing in—and unless you’re scaling and reinvesting in your business, that’s a major red flag.

Set a goal for a standard debt-to-income monthly ratio, with ranges for healthy high and low levels. This process will help you to sound an alarm if your ratio begins to rise—that way, you can intervene before your spending gets out of hand.

To rebalance your debt-to-income ratio, look for unexplained or unnecessary expenses. You can also acknowledge that some expenses are 1-time issues (like an unexpected plumbing repair cost at your business) that will return your ratio to normal in the following month. 

2. Lower Profit Margins

High sales totals don’t always indicate a successful business. A more reliable metric to look at is your profit margin. The profit margin is a metric that describes the amount of money (or percentage of profit) that a business makes from its sales. 

For example, let’s say you offer 2 products that both cost $20. If Product A costs $5 to make and Product B costs $15 to make, then Product A is significantly more profitable to your business. So even though these products are priced the same, their costs are different—which means they have different profitability (profit margin).

You can’t always control what your customers buy. However, you can create a diverse product offering and prioritize marketing your higher-margin items while continuing to focus on optimizing your company-wide profit margin. 

3. Excess Inventory

Inventory that you haven’t been able to sell is called dead stock. This term refers to items that get stuck on store shelves or in warehouses before they can get moved to the store or shipped to customers. 

Excess inventory means lower profits. First, you have to pay for warehouse space for the inventory that isn’t selling. Next, your shelves become full of unwanted items, which limits your ability to bring in new, highly desirable products. 

Even if you do sell your dead stock, you’re more likely to take a loss. Think about a collection of unfashionable sweaters that’s discounted 75% by May or the Christmas decorations that immediately go on clearance after December 25. At some point, you just want to get rid of the inventory and move on. 

If you consistently have problems moving your inventory, you may need to reconsider how much of a given item you buy or change your buying patterns to acquire more desirable items.  

4. A Large Account Receivables

When you send an invoice to a customer, it goes into your accounts receivables until those outstanding funds are collected. This is money you’ll have in the future but can’t use now. 

Watch to see if your accounts receivables build up—if they do, it could create cash flow problems in the future. Not only do you need to worry about customers not paying their bills (or taking too long to reconcile them), you also need to make sure you have enough operating cash to sustain your own liabilities and expenses. 

Like your debt-to-income ratio, set ranges for a healthy accounts receivable amount so you can intervene before the unpaid invoices become a problem.  

5. A Large Number of ‘Other’ Expenses

Within your financial records, you should keep most of your expenses categorized. You’ll likely have categories for materials, utilities, labor, marketing, and other costs. Unfortunately, not all of your business costs fall into these exact categories. 

Keep an eye out for a rise in “other” expenses that might fly under the radar but build up if you’re not careful. This is particularly relevant if your “other” expenses are large and contribute significantly to your debt-to-income ratio. 

You should look for ways to categorize these items and set budget items to avoid overspending.  

Many of the financial metrics above can change depending on the statement, time frame, or other variables you might use. If you notice any of the above red flags in your financial statement, it doesn’t mean the sky is falling—these are signals that should give you pause and lead you to investigate further, but they’re not completely damning.

For example, during the pandemic, you may have extended your net payment terms with clients. This flexibility with your customers could lead to an increase in accounts receivable—but within the context of the global pandemic, you can understand that it’s not indicative of a poorly run business.

The key to reading financial statements is to identify patterns and problems. If you can’t answer why these changes are happening, you need to take a closer look at your business. 

For better organization and financial planning, look into getting a software system that can help with bookkeeping. The Sunrise app can help you organize expenses, sort invoices, and make accounting a breeze. 

About the author

Derek Miller
Derek Miller
Derek Miller is a writer specializing in entrepreneurship, small business, and digital marketing. His work has featured in sites like Entrepreneur, GoDaddy, Score.org, and StartupCamp. He’s currently the CMO of Smack Apparel, the content guru at Great.com, and a marketing consultant for small businesses.

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