Whether you’re a proactive leader scanning the horizon for potential problems or a concerned entrepreneur afraid you’re already in the midst of a downturn, you need to know the early warning signs of financial trouble. Identifying these signals could be the difference between successfully navigating rough waters and going down in a shipwreck.
If you can keep your cool and understand why businesses fail financially, you will be able to spot these 8 early warning signs of financial trouble in your business.
What are the early warning signals in financial statements?
Accounting – the language of business – will eventually scream financial challenges in your monthly statements. But, if you listen closely and know what to look for, you will hear the whispers of earlier warnings and have more time to plan a response. These early warning signals include:
- Less than 3 months’ cash runway
- Diminishing quick ratios
- Gross margins < 20%
- Constantly growing inventory
Less Than 3 Months’ Cash Runway
This should cause you alarm as it signals immediate danger. Your cash runway is the lifeline of your business, dictating how long you can operate under current conditions before needing additional financial resources. Cash flow issues endanger every business element.
A runway shorter than three months indicates urgent action is needed to either:
- secure more funding,
- increase cash flow, or
- cut expenses.
Most of these actions require several weeks to gain traction, so 3 months is just enough time to perform evasive maneuvers and evaluate their success.
Diminishing Quick Ratio
A healthy quick ratio (current assets divided by current liabilities), ideally around 1:1 or higher, signifies that a company can cover its short-term liabilities with its most liquid assets. The quick ration requires no complex financial analysis – just simple arithmetic on the balance sheet.
A declining trend here could point to growing liquidity issues – especially poor AR collections and pushing AP payments – making it harder to respond to unforeseen challenges or take advantage of new opportunities.
Constantly Growing Inventory
Inventory levels that increase without a corresponding rise in sales means one of two things:
- Purchasing and manufacturing beyond demand
- Poor cost accounting
- Inventory obsolescence.
Each of these issues overstates your profit on the income statement, masking the full extent of business financial trouble.
Gross Margins Below 20%
While acceptable gross margins can vary widely by industry, consistently operating with gross margins below 20% is financially challenging for anyone except Costco. Remember to always include labor, shipping, import fees, and other overhead costs when calculating your gross margins.
What red flags will indicate that the business is in trouble?
If you do not have a good finance team, you are more likely to miss the early warning signs in financial statements. These four operational signals can serve as red flags, indicating business financial trouble on the horizon:
- Shrinking sales funnel
- Surge in refund requests
- Frequent and aggressive vendor collections
- Inability to make payroll
Shrinking Sales Funnel
Does your sales team seem bored, worried, or unusually idle? No matter the cause, a shrinking sales funnel is the earliest sign of a downturn in demand and looming financial challenges.
Surge in Refund Requests
An uptick in refunds or returns is a clear sign of customer dissatisfaction, either with the product quality or the customer service experience. Cash flow issues are the short-term danger, but your reputation is the larger risk. Work quickly to address problems and shore up your reputation.
Frequent and Aggressive Vendor Collections
If suppliers are increasingly demanding faster payments or employing aggressive collection tactics, your finance manager is likely running out of cash to pay them with. Aside from being a symptom of a much bigger problem, strained vendor relationships will disrupt your supply chain and endanger your productivity.
Inability to Make Payroll
Missing payroll isn’t an early warning sign – it’s the final wake-up call to a problem you have ignored for months. If you cannot make payroll, you may be able to still save the business, but it will require fast action and some luck.
Turning around your business
Identifying these early warning signals and red flags is just the first step toward safeguarding your business’s financial health.
If you spot a warning sign, engage with your team early to discuss the issue and evaluate the risk. Early and frequent collaboration with financial professionals ensures that you not only navigate through potential financial downturns but also emerge stronger, with a revitalized and more resilient business model. Our fractional CFO services provide an outside set of eyes to quickly detect business financial trouble.
