Financial Red Flags Small Business Owners Should Watch For

In our previous two articles, we discussed how to understand your business’s financial statements, and then explained how common bookkeeping mistakes can keep those financial reports from being reliable.  This month, we want to help small business owners be aware of some financial red flags that their numbers may be showing them.

To be clear, a “red flag” does not automatically mean that there is a problem, and it certainly doesn’t mean your business is doomed to fail.  Rather, these signs can be helpful early signals from your business that could clue you in to a fixable problem, before the problem becomes more serious.  And since we’ve got decades of experience and have had the opportunity to work with small businesses in industries such as oil and gas, medical, pet care, automotive repair, and more, we’ve seen and learned to recognize signals that indicate deeper financial problems, and we’ve also helped businesses work through these problems.

What Are Financial Red Flags in a Small Business?

In the context of small business finance, when we say “red flags,” we simply mean warning signs that could be indicative of larger problems. Red flags, such as one unusual number on a report, don’t always prove that something is wrong, but they should prompt curiosity to dig a little deeper to figure out what the issues are, if any, and then to figure out a solution-oriented plan. Much like the lights on your car’s dashboard, a financial red flag should be viewed in context, among trends, and with knowledge of the individual business. And again, like your vehicle, regular review and maintenance can help you to notice and potentially fix problems and make changes sooner. These red flags may surface through regular review of your financial statements, whether you review them yourself or with a professional.

Financial Red Flags to Watch for in Your Small Business

Cash Flow Problems and Growing Accounts Receivable

“We’re making a profit – Why don’t we have any money?”  We’ve heard this one before, and it comes down to the distinction between profit and available cash.  If cash consistently feels tight or seems to be declining, there could be a cash flow problem or a spending problem; A company can be making a profit on every job, but then spending too much on things that aren’t part of the cost of the goods or service. For example, just because your business is making a profit for each job doesn’t mean you can overspend by entertaining customers or taking excessive distributions.

Pro Tip:  Your business’s Cash Flow Statement may help you figure out the “mystery” of how and when money is moving (flowing) in and out of your business.

Aside from cash declining, growing Accounts Receivable due to customers taking longer to pay can spell trouble for a business if not dealt with properly.  In this case, revenue might be recorded, but the cash isn’t actually available yet due to delayed, sluggish, or late payments from customers. In our experience, multiple things can contribute to this.  Lengthy net terms may not encourage timely payment.  Furthermore, when there is an economic downturn, whether generally or in a specific industry, it is common to see customers stop paying invoices and bills on time.  This especially affects service industries and bulk sales companies, and it can subsequently affect a business’s ability to cover operating expenses.

Rising Expenses and Declining Profit

Expenses rising faster than revenue can be a warning sign that something may need to change.  Similarly, if your business’s profits are declining and margins are consistently shrinking, this can signal incoming problems.

Pro Tip:  A Profit & Loss Statement (also known as a P&L or an Income Statement) can help you look for trends over time in your business’s numbers, rather than assuming one unusual month means certain doom.

Potential causes of declining profit could include rising supply costs, pricing of goods, decline in demand, or a combination of these factors.  For example, shrinking margins have driven restaurants out of business when food prices (supplies) have skyrocketed and they didn’t adjust their menu prices fast enough to help counter that change.

Growing Debt and Difficulty Meeting Financial Obligations

Some financial red flags don’t appear in isolation, and more red flags may pop up if earlier warning signs aren’t dealt with properly.  The previously-mentioned signals of cash flow problems (slower-paying customers, rising expenses, and/or declining profits) can eventually contribute to a business’s increasing debt or difficulty meeting its financial obligations (even foundational ones like payroll).  These later signs indicate that a closer look at what’s happening in the life of the business is needed.

Pro Tip:  Your business’s Balance Sheet should show what your business owes (its liabilities).

If you’ve noticed that the business is struggling to pay things like bills, payroll, and taxes on time, this is important to address sooner rather than later.  Consider whether the business is increasingly relying on borrowing (debt) to operate.

In practice, we’ve seen variations of this during downturns in the oil and gas industry, when challenges in one industry can ripple through an entire local economy.  Customers may begin paying more slowly, creating a cycle in which businesses waiting to be paid struggle to pay their own vendors on time.  Because so many businesses in the area depend directly or indirectly on the oil and gas industry, the effects can spread well beyond the companies operating in that industry.  Some businesses may ultimately take on additional debt to cover regular expenses like payroll to keep their businesses going, which can have lasting consequences.

In another example, we once worked with a business owner who was surprised by a large tax bill.  They couldn’t understand how they could owe so much in taxes when there never seemed to be any money available.  A closer look showed that the business was profitable, but much of its available cash was being spent on discretionary spending, owner distributions, and personal expenses.  The problem wasn’t a lack of profit – it was how the cash was being spent.  After all, profit and available cash aren’t the same thing.

What Should You Do When You Notice a Financial Red Flag?

1. Make sure the underlying information is accurate.

First, it’s essential to ensure accurate and timely bookkeeping; remember, “garbage in, garbage out” – if your foundation of data is incorrect, then any conclusions you draw from your financial reports will be flawed or misleading as well.

2. Investigate why the change occurred.

With that in mind, if you notice a financial red flag in your business’s numbers, it’s also wise not to panic.  It could be due to inaccurate input or simply a fluke, so it’s worth taking a closer look to understand why the change occurred.

3. Compare results over time.

One practical step is to compare the current numbers with previous time periods, like preceding months, quarters, or previous years.

4. Compare performance with your budget.

Additionally, you can compare the business’s actual results with its budget and look for significant discrepancies.

5. Decide whether action is needed.

Once you’ve identified the source(s) of the red flag, consider whether action is needed.  This could include changing collections policies for outstanding bills, adjusting the business’s spending, or changing pricing for your goods and services.  Furthermore, if you want help interpreting your business’s financial books or statements, or if you would like help strategizing what to do next, asking your accountant or bookkeeper for assistance can be a valuable next step.

Regular Financial Reviews Can Help You Catch Problems Earlier

There are practices that we recommend as preventative measures to help you catch and deal with problems earlier, some of which we discussed in our last article.

We recommend regularly reviewing your transactions and reconciling your accounts each month.  Once your accounts are reconciled, review your financial statements – such as your Cash Flow Statement, Balance Sheet, and Profit & Loss – to evaluate your business’s financial health and trends over time.

Your business’s financial statements aren’t just for tax time; they are tools for running your business throughout the year.  Insights drawn from the financial reports aid in planning and decision-making for your business.  And accurate, timely bookkeeping makes this kind of monitoring possible and productive.

If you don’t have the bandwidth, expertise, or desire to handle your business’s bookkeeping, it could be time to entrust that to a professional.

You Don’t Have to Interpret the Numbers Alone

Spotting financial red flags within your small business’s books is only the first step.  Understanding why these changes have taken place can require more investigation, context, and expertise, but you don’t have to do this alone.  Grace & Growth Financial Services partners with business owners to help them maintain accurate books, understand their financial reports, and proactively identify areas that may deserve attention.

If you could use more support for your business, contact us today for trusted, caring guidance and support.