9 Red Flags Revealed in Financial Statements of SMEs and Start Ups – Part 1
This is a continuing article in my series on Corporate Governance (CG). This series is dedicated to Start-Ups and SMEs as issues of CG in large corporations are complex and require multivariate observation to understand. I would probably write a series for large companies sometime in the future.
The purpose of this series is to guide business owners and to-be-entrepreneurs to understand the critical areas in financial statements and use it as a management tool to strategize plans to sustain or grow the business. Do bear in mind that banks, government agencies, lenders and investors would analyse these areas to gauge the health of your company and to make their decisions to lend or invest in your company or otherwise.
This list is not exhaustive and is presented in short points without detailed explanation but sufficiently to serve as a preliminary guide. It is important to note that managing financial risk is the responsibility of directors and key persons. When auditors detect any irregularities in the financial statements and have signed them off as a qualified report, it may be a little too late to save the company from a black mark.
Financial Statements are made of 3 key parts comprising Income Statement (P&L), Balance Sheet and Cash Flow. These parts should be read as ONE to understand the correlation between all three within the same accounting period, be it the same month, same reporting quarter or same financial year-end.
Let’s begin with the Income Statement.
- Aggressive Revenue Recognition
Usually, revenue is defined as actual sales invoiced and it does not include ‘agreed’ sales. It is always excellent news when a business is generating good sales. However, when sales surge unprecedentedly high as compared to previous accounting years or disproportionately with the industry benchmark, this should certainly invite a detailed look. Checking the reasons behind sudden high recorded sales should be high in your checklist.
- High Revenue vs Low Expenses
Cost of goods and other operating costs would increase proportionately with the increase of sales. When there is a big disparity between these figures, it may trigger suspicion that the numbers may be cooked up unless the disparity is justified.
- High Growth Profit Margin vs Low Industry Margin
Profit, profit margin, and profit margin growth rate, co-relate with price, sales and cost. When a business is growing with an increasing profit due to better margin which is not in line with industry performance, this will trigger suspicion. Certainly, there are businesses which have shown such a sudden increase in profit margin. This could be brought about by utilizing essential raw material acquired earlier at low costs, or by merger or business acquisition, or in the case of property development, and inherited land.
We have Part 2 to be published on Friday, 19th Feb 2021. Do follow me in my next article.