Financial statements help managers, lenders, and investors evaluate an organization’s financial performance. However, they only tell part of the story, and they might not reveal financial distress until it’s too late, especially for organizations that only issue annual reports. So, it’s critical to keep an eye out for these five common red flag indicators that an organization may be struggling to make ends meet:

1. Financial Reporting Delays. Late financial statements may signal unqualified accounting personnel, inadequate recordkeeping, or even fraud. In some cases, the organization’s controller or CFO may be reluctant to show uninformed owners how severe the situation has become. Or management may procrastinate over concerns that lenders will call loans or refuse to waive covenant violations.
2. High Employee Turnover. Employees, who are often the first to recognize problems, may abandon ship when they’re aware of financial distress. In particular, stock options motivate employees to leave the organization before their options lose additional value. Turnover is especially problematic when it involves hard-to-replace executives because it can have a ripple effect that lowers morale for the remaining staff.
3. Fixed Asset Auctions. Healthy organizations routinely invest in new equipment and upgrades. However, struggling organizations may sell fixed assets to boost operating cash flow. Auctions bridge temporary cash shortages and help purge an organization of idle or outdated equipment. Unfortunately, they don’t always work as intended. Auctioning equipment compromises an organization’s ability to generate future income, especially if management liquidates valuable operating assets at fire-sale prices.
4. Questionable Accounting Practices. When business owners try to hide deteriorating performance, they often devise creative accounting strategies to increase sales and profits. For example, an organization may engage in above- or below-market, related-party transactions. Management might also make aggressive accounting estimates to overstate asset values or earnings.
5. Frequent Or Haphazard Loan Requests. Maxed-out credit lines and frequent new loan applications may indicate something’s awry. Each time an organization asks for loan proceeds, it should have a detailed plan for how management will use the funds. When cash is tight and loan requests are denied, stressed business owners may become desperate. For instance, they might take on debt with unfavorable terms or use their personal credit cards to fund their organizations’ working capital needs.

Be On The Lookout

Organization insiders are usually better equipped to notice these distress signals sooner than outside stakeholders. However, ongoing due diligence can help. For instance, if you have a financial interest in a particular organization, consider reviewing news stories for recent developments, following the organization and key employees on social media, scheduling quarterly meetings with management, and visiting facilities that are publicly accessible (such as retail stores and job sites). A lender or franchisor who suspects an organization’s performance is deteriorating may even request an agreed-upon procedures engagement that targets perceived weaknesses and recommends possible improvements. Contact us for more information.