A company’s financials provide important information regarding current economic wellbeing and, if you know what to look for, can provide information on potential future success or failure. Whether you’re an auditor, a tax accountant, a company looking to acquire another entity, an investor providing growth capital or an individual buying stock, you will need to perform a thorough analysis of the client/target company’s financials to make sure things are in order. When something jumps out as a potentially bad scenario, it should be further investigated. In this blog, I will point out common red flags to help avoid any surprises.
Common Red Flags
The following list offers areas of interest to focus on when analyzing a company’s financials:
1. Cash balances– How much cash do they have? How much cash are they able to maintain? How quickly do they spend cash?
2. Cash flow – Look at the statements of cash flows and taking into consideration:
- Operating cash – How much cash flow is generated from operating activities? Are they bringing in cash or is it going out the door? Can they continue as a business? (It’s a good sign if they have positive operating cash flow.)
- Free cash– What is their operating cash flow minus capital expenditures? How much cash is needed to maintain the business? Is there any excess cash to pay down debt, issue dividends to shareholders, expand the business, etc.?
3. Borrowing capacity– How much debt do they currently have? What is their ability to pay short-term debt obligations, i.e. coming due in the next 6-12 months? Do they have any lines-of-credit? If so, how much is currently outstanding and how much availability is left to use? Usually, the maximum availability on a line-of-credit is determined from a borrowing base calculation and may not be as simple as the maximum amount of the line-of-credit less the outstanding balance. (Borrowing capacity is a good sign; if tight, it can restrict business growth or the ability to meet daily operating cash requirements.)
4. Profitability– What is their gross profit margin/percentage? (A higher percentage means a better position to make money.) Looking at pricing year over year, were price increases received from vendors passed on to customers or absorbed by the company? Are they able to sell at the needed margin to stay in business? What is their EBIDTA (which can be a good measure of profitability)?
5. Other expenses– Do they have any other high expenses not part of cost of sales? What are those costs for? Are they recurring or one-time costs? Are they classified properly, i.e. should they be considered cost of sales and they’re not?
6. Net income– Do they have a history of making money or losing money? (It’s a red flag if they’re losing money!) Remember to look at non-cash expenses in this analysis. Such as, is there a lot of depreciation expense that might be distorting net income or loss?
7. Contingencies and commitments– Are there any lawsuits or potential lawsuits? Do they have any outstanding guarantees or off-balance sheet commitments? How about operating lease commitments, purchase commitments or contingent liabilities (a future event that may or may not happen, but which might affect future payouts)?
8. Financial ratios and liquidity– Are their financial ratios poor? (If so, it might indicate problems or issues.) Examples of some ratios are debt to equity (total liabilities over stockholders’ equity), and working capital (current assets over current liabilities). A high debt to equity ratio or low working capital ratio might indicate their inability to service debts/liabilities as they become due or that debts/liabilities are growing faster than their ability to service them.
9. Inventory turnover ratio and inventory balances– Is there low inventory turnover during the year, such that it doesn’t turn into cash very fast or is unable to be sold? (If the inventory balance is increasing every year, it could indicate that there is potentially old, obsolete inventory that is unable to be sold, as well as more cash, is tied up in inventory and unavailable to pay down debts, expand the business or return to investors.)
10. Aging of accounts receivable– Are there older accounts receivable? (If so, this could indicate an issue collecting cash from customers.)
11. Debt covenant ratios– What are the debt covenant ratios for any debts or lines-of-credit? Is the company in compliance with those ratios? Do they project to be in compliance with the ratios in the future?
In cases where a financial analysis raises areas of concern, I suggest having a discussion with the company’s management to better understand the situation and bring it to their attention. It is always good for management to be reviewing their financial statements to head off possible problems and proactively make adjustments to business plans.
If you want to know your company’s own financial health, Weinstein Spira auditors can assist you during your next audit. That way, you’ll be ready for not only preparing your financial statements, but you’ll know what they say about the company before someone else takes a look.