If you read the headlines of national and local news, it is amazing that so many businesses are seemingly strong one day, and the next they are closing or filing for bankruptcy.
One of the many reasons this happens is that business owners and managers don’t pay attention (or don’t want to acknowledge) the financial warning signs that could have saved them. By the time the financial collapse starts, it’s often too late to change course.
6 Warning Signs You Can Look For
To help you spot these warning signs, here are the 6 financial red flags that we coach our clients to take action against:
- [The Most Telling Sign] Cash Holdings and Equity Are Lower Compared to the Previous Periods
Take a look at your balance sheet and income statement to determine your overall cash holdings and equity (Assets-Liabilities). If your liabilities are higher, ask why. Negotiate terms to lower credit rates, extend payment terms, etc. Involve other departments to determine how your business can operate more efficiently and cost-effectively. Discuss simple ways to increase revenue without significantly increasing overhead. - Days in Accounts Receivable Increasing
Many customers are pushing the envelope with their payment terms. Create a process for collecting outstanding receivables, and ratchet it up when customers start paying late. Customers often pay those vendors with strong systems, and delay payment to those suppliers who don’t have solid collections practices. This doesn’t mean that you won’t work with a long-standing customer who asks you for some flexibility. It does mean that you implement smart AR strategies such as late payment fees, outsourced collections help and credit reporting with clear communication and consistency. - Not Enough Cash Flow for Accounts Payable
Order in smaller quantities of goods/services from your suppliers. Talk to vendors to negotiate extended terms, leveraging your long-standing relationship and good business practices. Use a credit card with 60-day terms to maximize the number of days to pay (make sure to review your credit card agreement and understand the terms). Search for discounts for paying within terms if your suppliers won’t stretch the terms. These strategies may not impact your cash flow immediately, but they can have an overall impact by improving your bottom line, since you are buying product or services at a lower price. Get a good handle on your inventory, turn rate, spoilage, sales trends, etc. so you actually buy smarter. - Evaluate Profit Margins and Turnover Ratios
We all know that decreasing profit margins are a bad sign, but they can’t be evaluated alone. Turnover ratios are also an important factor. Remember, mega grocery stores and warehouse clubs have low profit margins, but high turnover ratios that result in adequate net income and, more importantly, reasonable cash flow. The key is to look at both your profit margins and turnover rates together because how they interact will ultimately tell you how much cash has flowed into your bank account. - Indirect Overhead Growing with Increase in Sales
Take a hard look at operations. Are you running as efficiently as you could be? Are your employees productive or can they take on more responsibilities? There are more costs to adding employees than just salary, benefits and taxes. You have equipment, space, recruiting/training time, etc. for each employee you hire. The goal is to increase sales without increasing your fixed overhead. If you find there is nothing you can do to avoid increasing your fixed costs, you might need to re-evaluate your business strategy to determine how you can raise your profit margins to accommodate for your increase. - Warning Signs Outside Your Business
Every business should use and review a weekly dashboard that includes many of the warning sign financial metrics listed above: gross profit margin, average daily outstanding AR, inventory turns, days payable outstanding, available line of credit, operating profit margin, etc. But ultimately, there are other warning signs that may not be on your dashboard. Below is a story from a business who engaged a trusted advisor for an outside perspective.
A Real-World Example of Heeding the Warning Signs
“Most people under-emphasize the available line of credit,” says Joe Dresnok, a consultant with Management Horizons. “The perfect storm for a company is a down economy, reduced sales and the inability to reduce overhead. When this happens, a company needs to access their credit lines to get through the tough times, and invest in other avenues to generate revenue.”
But during a slow economy, banks will reduce credit lines. One of Joe’s clients had a $300,000 line of credit, of which they had drawn down 1/3. Joe and his team recommended the client draw down the rest of the credit line. Within 30 days, the bank came to give the “bad news” that they were reducing the company’s credit line to $100,000. The company was happy to report they had already tapped out all $300,000 of the original credit line. “In essence, they preserved $200,000, which translated to staying power.” In this case, it was definitely worth the cost of that credit to preserve the line.
Each company has its own specific set of measurements (metrics) to help owners understand what to look out for in their financials. (Here are the 8 essential financial metrics we recommend tracking.) This will at least give you the chance to prevent your company from embodying a quote from Ernest Hemingway: When asked how one goes bankrupt, he said “Two ways: Gradually, and then suddenly.”
Watch for the warning signs!