Financial reports are the most empirical way to evaluate an entity's well-being, and as they say- the numbers don't lie. These numbers sometimes imply that all is well and will also notify the first signs of trouble if they are approaching.
Historical failures, like the infamous Enron scandal, shows that financial reports are subject to inaccuracy and misstatement. These glitches are often not palpable, difficult to detect, and may even be hidden. Knowing what to look out for is critical in bringing these problems to light.
Red Flags to look for in Financial Statements
Business owners and potential investors who analyze financial reports must know and should be able to identify any red flags that indicate that the financial numbers could be wrong.
Here are some of the red flags to look out for:
1. The numbers are too good to believe
If the numbers are fab – then they must be true.
So, what is "too good to be true"?
After analyzing the statements, if you find that the numbers are far better than the estimates or observe that the company has suddenly outperformed the competition; this is the situation when the numbers would be too good to believe.
It is often advisable that when your gut says something is fishy, you should not ignore it. If, while preparing or reviewing financial reports, you don't have confidence in the numbers, take action, and investigate. Understanding the 'why' behind these numbers is very crucial.
2. Auditors Vs Management
A frequent change of auditors, due to disagreement or other reasons, can be a cause of concern.
Throughout an audit, auditors trace all errors, noting which have been corrected, and which haven't. This is usually called the 'Summary of Misstatements' which is included in the Auditor's Report.
Management and auditors can sometimes have different opinions and can get in conflict. One such instance can be when the management is unwilling to fully recognize early potential losses, but auditors decide to take a conservative view. Differences like these can manifest into errors and misstatements within financial reports, which are often seen in provisions such as warranties, stock obsolescence, and doubtful trade debtors.
3. Accounting Policies
Unusual accounting policies, practices, and methods can sometimes point to misstatement and make it difficult to compare performance to similar businesses. An instance is the R&D tax incentive which could be reflected in three different ways:
- Grossed up as the number in other income.
- As the net of tax in Other income.
- The net benefit of incentive reflected in the Tax Expense line of the profit and loss statement.
These different applications result in different EBITDA and Net Profit before Tax.
The estimated asset lives that vary from industry norms may trigger an under-recognition of depreciation expense, overstating profits, or balance sheets with values assigned to worthless assets. When estimated asset lives differ from industry norms, something is wrong.
4. Changes in Financial Reporting
These changes can be in many forms:
- Trends in the B/S and P/L ratios.
- Multiple and larger late adjustments to monthly management or annual accounts due to errors or inaccurate data.
- Change in senior management which could mean a change in management style and internal culture.
Any change inside the entity should be flagged and understood, considering the impact it could have on the financial reports.
At the point when you take a look at the financial statements of an organization and discover abnormalities like numbers higher or lower than anticipated, it should fill in as a warning. On finding such peculiarities, one should take a glance at the accompanying perspectives:
- Investigate the P/L statement: If you see the 'Other Expenses' category extremely high or spot an abrupt rise in legal fees or an endeavor to conceal over the top travel costs, it is an indication of a possible issue.
- Marketing projections are acceptable; however, most of them actually belong to the most recent couple of days of the month or the past quarter
- An abrupt flood in the estimation of fixed assets or intangibles more than estimated can suggest that expenses are being capitalized.
Complex exchanges, both internal and externals, that are not perceived or don't seem to have a sound economic basis, ought to be regarded as an alert. Returning to our model from above, Enron used 'limited liabilities SPVs' to move risk from its records. Today, comparative complex structures can often be abused to deceive people.
7. Bonuses based on Performance
In certain organizations, the remuneration of the management team is linked to the performance of the organization. Thus, senior administration has an immense impetus to manipulate the outcomes.
In some cases, the management team is granted rewards for short-term performances of the organization. This could prompt choices that are not valuable for the organization in the long haul. It is advisable to give close consideration to this perspective as well.
8. Rising Gross Profit Margins
Gross Profit is utilized to compute the extent of money left over from revenue after representing the COGS. An expanding Gross Profit % may not generally be a decent sign, especially when overheads are more than outperforming it or sales are declining, as this inevitably prompts a net loss.
Gross Profit Margin should not be observed in solitude but observed together with sales levels and overheads.
9. Rising Debtors
Where an entity is nearly breaking a debt contract, and the loss of a credit facility is approaching overhead, the board often tends to misquote the records or the computation of the covenant leverage ratios.
To check the capability of such looming issues, one should get more detail on the contracts themselves, and the degree of safety margin.
It is difficult to identify red flags. Nonetheless, identification, examination, and resolution are frequently technoscientific, and on occasion, past the expertise of any one person.
For all entities, it is important that the financial reporting is done precisely, and that there are 'checks and balances' set up to evade any undetected mistakes and errors in the financial reports.
It is constantly prescribed to have a specialist involved in the financial management or review of any financial reports. Regardless of whether you're an entrepreneur or financial specialist, acquiring and understanding the right data is the genuine main approach to make a sound and fruitful choice about your next move.