7 SIGNS OF BUSINESS TROUBLE AND HOW TO IDENTIFY THEM:
How do you know if your business might be in financial trouble?
Running a business is no easy feat. It is a task that requires careful financial planning and management to ensure its success, and despite the best efforts of some business owners, there are times when financial difficulties can still arise. The repercussions of ignoring or failing to identify the early warning signs of financial hardship can be severe and may at times result in business liquidation. Therefore, it is essential for business owners to exercise caution and be alert to any warning signs that suggest their company might be experiencing financial difficulty.
It may come as a surprise, but business owners can routinely neglect to evaluate the financial standing and future prospects of their company mainly due to their focus being on day to day operations, paying bills and salaries, all too often understanding the harsh realities of financial trouble when it’s too late.
Maintaining a close eye on your business’s financial health and performance might be the difference between your company recovering from difficult times or business rescue or liquidation. In addition, evaluating your company’s financial performance and future prospects on a frequent basis is a critical business control that falls under the responsibility of the owner or CEO.
Below we discuss a few indicators that you can use to identify if your business is in trouble, followed by some advice on how to stay on top of your company’s performance. Please bear in mind that this list is not exhaustive.
TECHNICAL INSOLVENCY
This is when the liabilities of the company are more than its assets. A quick way to check this is to ask your accountant for the business’s latest set of financial statements or management accounts and look at the Total Equity / Owners’ Equity section on your Balance Sheet. If this is negative, then you are technically insolvent. This would indicate that your company is spending more cash than what it is generating, and chances are, you have already secured a loan or are considering it.
DEFAULTING ON LOANS
This is when you cannot repay debt finance (i.e. loans) within the agreed-upon terms. This is not a good sign as it is a clear indicator of cash flow problems, especially if your debt finance is held with traditional banks as they generally do not allow much time to rectify before calling in their security. If you find yourself struggling to pay bills or meet financial obligations on time, it could be a red flag that your business is in financial distress.
OPERATIONAL BORROWINGS
This is when your company borrows money to fund its operational cash flows outside of an off-season fluctuation or a once-off event. In other words, the cash flow that you generate out of your normal day-to-day operations should be more than sufficient to cover the day-to-day expenses. Operational borrowings may indicate that your business is not generating enough revenue to support its operations, or that your costs are too high and need to be reduced.
Pro Tip: High debt levels can increase your interest expense, decrease your cash flow, and impact your creditworthiness, making it difficult to secure financing or credit in the future.
PUSHING CREDITOR PAYMENTS
Insufficient cash flow frequently forces businesses to postpone paying creditors. This may be feasible for a little while, but is a clear indicator that there is a cash flow issue. If this issue is not addressed, it will ultimately become unsustainable and result in the creditor/s calling default on overdue debt. Late payments to creditors can also negatively impact your business relationships and credit score.
CONTINUOUS INVENTORY WRITE-OFFS
Theft, wastage, large inventory holdings, or expired stock are all potential sources of ongoing high levels of inventory write-offs, all of which may severely affect your cash flow. One of the most targeted areas of any company is inventory, and if improperly managed, may result in significant cash flow leakages. Shrinking gross profit margins could also indicate a potential problem with the cost of goods sold, stemming from inventory write-offs.
SHRINKING CUSTOMER BASE OR SALES VOLUME
If your client base or sales volume is consistently declining year over year, this may be a sign that your company is losing market share and, if unchecked, might eventually cause cash flow issues due to a failure to generate enough revenue to pay expenses. Declining margins might make it more difficult to reinvest in your company or accumulate cash reserves, making it more susceptible to financial problems.
SHRINKING NET OR GROSS PROFIT MARGINS
If you notice that your gross profit (your sales minus the cost of goods sold) or net profit margins (the bottom line) are continuously shrinking year over year, this could indicate that your business is either losing sales, or there is an increase in your cost of goods sold or overheads.
A drop in sales could be due to heightened competition, poor service, pressure on pricing or incorrectly priced goods or services. Market research is key in this situation to understand the root cause. If left unchecked, this could ultimately lead to cash flow problems from insufficient sales to cover overheads. On the opposite side, increasing expenses could be due to supplier price increases, badly negotiated pricing, high levels of inventory write-offs or excessive expenditure, all of which require an internal review and cost cutting.
A quick way to check this is to ask your accountant for your last three years of financial statements. For the gross profit margin, divide your gross profit by the revenue, and for the net profit margin, divide your net profit by the revenue.
If your business is exhibiting any of the aforementioned symptoms, this may be a sign that your business is in financial trouble.
The aforementioned may not be a cause for alarm on their own, but they should be evaluated as a whole and in the context of your company environment as well as the seasonal fluctuations that many sectors experience. To help business owners and CEOs ensure that they maintain awareness of their financial status and performance and receive fair warning of troubled times.
WE RECOMMEND THAT THE FOLLOWING CONTROLS BE PUT IN PLACE AT A MINIMUM:
CREATE A BUDGET AND ONGOING FORECASTS
A budget is a critical business tool that is used not only to forecast the company’s position and performance over the next 12 months but also to plan how you are going to set about achieving your targets, what the shortfalls are and how to fill them, and what funding will be required if any.
Monthly or quarterly forecasts will then project your financials to the end of the year and beyond, based on the latest set of information. Creating a budget and forecasting your business’s financials can help you plan for the future and identify potential financial challenges. Budgets will also instil accountability by setting targets for the respective departments and staff to which they can be managed.
Pro Tip: Use budgeting and forecasting techniques to estimate future sales, expenses, and cash flow, and identify any discrepancies or deviations from your projections in your management accounts (See below) and provide corrective action if needed.
REVIEW OF MONTHLY MANAGEMENT ACCOUNTS
This is another critical management control whereby you as the owner or CEO are responsible for reviewing the monthly management accounts to ensure that the company is on target in terms of the budgets set.
It’s essential to regularly monitor your business’s financials, including revenue, expenses, profit margins, cash flow, working capital and debt levels. Therefore, reviewing financial statements such as income statements, balance sheets, and cash flow statements can provide valuable insights into your business’s financial health.
A good set of management accounts should include financial information such as an Income Statement with variances to budget, a Balance Sheet and a Cash Flow Statement, as well as any non-financial information such as Sales and Marketing Data, Operational Information, and Human Resource Information if you have enough employees to justify.
We recommend reviewing your management accounts on a monthly basis to find areas where you can save without sacrificing the quality of your inventory, and investigate cost-cutting options (including improving supplier contracts, streamlining the manufacturing process, or lowering pointless overhead costs).
Pro Tip: We recommend utilising appropriate accounting software for in-house accounting, an outsourced accounting firm or hiring a professional accountant if possible, to maintain accurate and up-to-date financial records.
BETTER CASH FLOW MANAGEMENT
Cash flow is the pulse of any business, and effective cash flow management is crucial to staying financially stable. To ensure that you have adequate warning of upcoming cash flow needs and possible shortfalls, cash flow forecasting is a must.
Together with strong enforcement of debtors, creditors and inventory management policies and procedures, these will ensure that you are maximising your cash flows and can see what your upcoming cashflow needs will be. In short, these are achieved by actions such as shortening your customer collection periods and staying on top of overdue debts, negotiating favourable payment terms and pricing with suppliers, or optimising inventory levels and wastage.
We suggested that you monitor your cash flow regularly, identify any gaps between cash inflows and outflows, and take appropriate actions to ensure adequate cash reserves.
IMPROVE INVENTORY MANAGEMENT
If your company deals with inventory (Raw materials, semi-finished or Finished goods), it is essential to have effective inventory management processes and procedures in place to keep inventory theft, waste, expired goods, and holdings to a minimum.
This is always a targeted area of any business that, if ignored, may cost the business a lot of money. Good inventory management has controls around the levels of procurement, receiving, storing, issuing, and holding of stock, as well as bi-annual stock takes at a minimum.
Be sure to keep a watchful eye on rising levels of inventory write-offs or decreasing gross profit margins when reviewing your management accounts.
Should your business encounter financial trouble and require assistance with evaluating its financial status, implementing the necessary changes, or establishing controls, CompassPoint Consulting is here to help you.
