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Balance Sheet

  1. High Inventory Rate Vs Low Sales

When a high inventory rate is recorded, it means the turnaround of the stock is fast to produce the finished goods. However, it does not make sense with a high inventory rate but a registered low sales volume. Leakage in the supply chain could likely be one of the reasons.

 

  1. High Loan Amount to Directors

When excessive amounts of loan to the director(s) are recorded, lenders view this as the company is not using its cash inappropriate manner, or directors are misusing company funds or moving cash out of the company.

 

  1. High Receivables Vs Unhealthy Aging

Trade receivables are acceptable if it falls within 1-2 months or within the industry credit terms offers to clients. However, a high percentage of receivables for more than 4 months is showing signs of an unhealthy collection pattern.   

 

Cash Flow Statement

It is inaccurate to conclude that the total cash collected is the same as total revenue for the accounting period unless your business is based on hard cash received upon issuance of invoices in the same accounting period. 

 

  1. Cash paid out to questionable investment.

Cash has been paid out to invest in companies where directors have personal interests, for purchase of assets/properties/stock in individual names or assets which has no relation to the generation income for the company.

  

  1. High Revenue vs Low inflow of Cash

Such situations exist when a company has made lots of sales by issuing invoices but cash from sales is yet to be collected. Any uncollected cash from concluded sales of more than 6 months should require the attention of key executives.   

 

  1. High Paid Out to Directors/Key Management Vs Low cash for Business Operation

It is acceptable to pay out good remuneration but not when the business is facing tight cash-flow to pay the expenses of the business.  

 

As mentioned, this is not an exhaustive list. There are many other observations in financial statements that would benefit business owners. I hope the above 9 Red Flags help in your strategy to excel in your business or new startups. Don’t forget to follow me on my next article to get some insights on Red Flags revealed in Operation Process. 

 

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.

  1. 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.

 

  1. 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.

 

  1. 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.

 

The journey of a business commonly begins as a Start-Up. Whether it may progress to a Small Medium Enterprise or listed company or Multinational Corporations depends heavily on the business strategies and the capability of its owners or key persons. These 9 Red Flags serve as fundamentals for Start-Ups and SMEs to shape their strategies for growth and funding exercises.