Do You Look At Red Flags While Studying The Financial Statements

If you want to know how well your business is performing, deeply scroll through its financial statements. There, you can find the clear signals that highlight your success or failure. While growing numbers like revenues, profits, or assets initially may seem encouraging, they do not always give you a clear picture. Subtle inaccuracies that slowly transform into red flags in financial statements often hide in the rising debt levels, cash flow patterns, or accounting adjustments that may appear harmless at first but may create deeper issues if not addressed at the right time.

This blog talks about why identifying red flags in financial analysis is important and which red flags to look for in financial statements. Let’s find out.

Invest in Indian Markets and Unlock Future Potential With 5paisa!

Open Account Now

Why Identifying Red Flags While Studying the Financial Statements is Important?

Red flags in financial analysis are crucial indicators of financial distress, mismanagement, or costly mistakes. These can lead to reputation or financial damages, regulatory fines, or, in worst-case scenarios, even result in bankruptcy. Therefore, when analysing financial statements, identifying these clear warning signals or  ‘Red flags’ is important:

• Red flags can help you discover a decline in profits, low cash flow, or rising debt, highlighting your company’s struggle in meeting the expected finances.
• They can point out any fraudulent activity in accounts or highlight any audit irregularities.
• These can prevent investors from making any risky investment, or in protecting their funds or capital from any financial losses.
• Red flags discover potential risks, which help in maintaining stakeholder confidence.
• They can help companies stay compliant with legal and regulatory requirements, as any regulatory conflict can be detected proactively.
• A transparent due diligence of financial statements to identify red flags can strengthen trust, confidence, and business integrity. 

How to Perform a Complete Due Diligence of Financial Statements?

Before we jump into the different types of red flags in financial statements, you must know how to read the financial statements accurately. This helps in a deeper analysis of the statements rather than just a top-line assessment. Here are the four important components that you must analyse in the financial statements:

• Go through the auditor’s report: It consists of the statements prepared by the auditor and the opinions depending on the findings.
• Financial position statements: Statements about what the company owns in terms of assets, liabilities, and shareholder equity, and balance sheets.
• Income statements: These statements highlight where the company has generated income and where the expenses are made.
• Cash flow statements: A look into the company’s long-term and short-term financial investments.

Which Red Flags to Look For in Financial Statements?

You now know which areas to explore in the financial statements to catch the red flags and discover where your business needs improvement. Here are the top 8 red flags that you must look for in financial statements:

1) High debt-to-equity ratio: If you find that your company has a rising debt more than its capacity, then it's an immediate red flag. A larger ratio means your company has more obligations in terms of interest payments and has a high chance of bankruptcy if not dealt with.  

2) Large accounts receivable: During analysis, if you discover that there are too many accounts receivable, then this is a red flag. A sharp rise shows collection issues. That means your company is able to sell products or services, but is struggling with receiving payments for them. Which is/may eventually impact cash flow and profitability.

3) Increasing share count: If the company has a larger number of shares for purchasing, the more diluted is the shareholder’s stake. Check that, if the share count is rising by 2 per cent or more every year, this red flag indicates that the company is diluting its organisational value.

4) Several mentions of ‘other expenses’: If you find too many mentions of the ‘other expenses’ on your balance sheet, which is larger than the normal levels, then its definitely a red flag. You must find out for which purposes these ‘other expenses’ are being made. Checking the values of these expenses is critically important to understand how likely these expenses are to recur.

5) Apprehensive transactions: A company make several transactions with multiple customers, companies, and related parties. However, during your analysis, if you find that there are certain transactions that are made at prices that are not according to the market rates. (Considerably at low rates, with very minimal to no benefits). Then consider it as a red flag. You must find out which high-value product transactions are made at deliberately low cost.

6) Fluctuations in revenue: Both a sudden spike and a sudden drop in the company’s revenue are red flags. Especially if you know that there is no increase in the investment or a possible loss, then finding out the reason for a suspicious cash flow (in/out) is necessary.

7) Unusual salary expenses: During analysis, if you discover that your company has unusually high overall expenses on employee salaries or even low overall salary expenses compared to the number of employees working, then it is surely a red flag. These may point to a chance of money laundering or possible tax evasion.

8) Sustained profits or loss: A sustained loss or minimal profits over several years requires analysis. It can raise questions about business viability, or if there is a continuous loss, the industry experts may question why the company has not seized its operations. 

Conclusion

There are no fixed rules to find red flags in financial statements. Its a skill that improves with experience. Moreover, it is important to understand that not every red flag shows failure; some may also act as a warning sign or signal that needs your attention. So, whenever you are performing financial analysis, remember to do it with a balance of curiosity and caution. Identify different patterns, go for deep analysis, ask questions, and rather than assuming things for red flags, try to find out proofs in terms of data that help in making informed judgments.