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Looking for the Red Flags in Financial Statements

Financial statements are supposed to provide a picture of the past performance and current situation of a potential business partner’s financial situation. However, you are not always able to receive them, and if you do, it doesn’t mean the information is reliable.

When doing business, creditors must be wary of potential red flags that can pop up while reviewing these extensive reports. Johnson Controls Inc.’s Craig Simpkins, CCE, CICP, director of finance transformation, outlined a variety of factors that credit professionals should take note of when reviewing a company’s financial statements, during the NACM and FCIB webinar, Financial Statements and Red Flags in Credit Risk Management.

Although Simpkins’ focus was on international financial statements, the red flags he identified would apply to any set of financials, he said. Examples of red flags from a financial standpoint include:

  • Sudden or gradual increases in gross profit margin compared with the company’s prior performance. What’s driving that increase? That change should be noted in the financial statements, Simpkins said. For example, maybe there was a big initiative that cut general and administrative expenses within an organization.

  • Cash flows that are negative for the first three quarters followed by a positive cash flow for the fourth quarter. “That’s a pretty miraculous recovery,” which should be questioned, he said. Simpkins cited the Enron scandal that resulted from company leadership implementing fake holdings and off-the-books accounting methods as an example.

  • Significant sales to questionable business partners.

  • Sudden above-average profit for specific quarters.

  • Large last-minute transactions that result in significant revenue boosts for quarterly or annual reports.

  • Financial results that seem too good to be true or significantly better than competitors.

  • Consistently close or exact matches between reported and planned results. For instance, if the company’s results are exactly on budget or the managers always achieve 100% of their bonus opportunities.

  • Frequent or significant changes in estimates for no apparent reason, such as increasing or decreasing reported earnings.

In addition to financial trends, Simpkins advised credit professionals to make note of certain operating strategies such as:

  • Executives or board members that have direct dependence on the company’s performance.

  • A lack of board oversight of senior management.

  • Complex or confusing business arrangements that serve little practical purpose.

  • Frequent changes in auditors over accounting or auditing disagreements.

  • Overly optimistic communication with company higher ups to convince investors of future growth.

  • Hesitancy or a lack of specifics from management or auditors when questioned about financial statement findings.

  • Frequent differences in viewpoints between company management and their auditors.

  • Often ships the last week or day.

“There are many indicators other than financial results that indicate a company may be facing difficult times,” Simpkins cautioned. For this reason, he recommends also considering other credit risks such as poor prior credit history and how a company is addressing it, negative commercial credit reports and cash flow problems.


This article was first published in the July 22 issue of eNews. It is used with permission.

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