Red flags common in small/medium business finances

By James Chittenden

If you are looking to buy an existing small or medium business, protect yourself by looking for red flags in small/medium business finances. If you are looking to sell a business, clean up your books and implement the controls we recommend below.

Clean finances increase the value of a business. Sloppy books decrease the value of a business. Here are six simple questions and their answers, followed by ways to strengthen the integrity of your small/medium business finances.

Q/A

Q1. What are the most common red flags found in financial statements?
A1. Some major red flags are as follows:

Inventory turnover slowing, along with slowing sales.
Payables up, receivables down.
Aging receivables, more than 60 days.
Vague marketing spend without specifics.

Q2. What should we look for if a business offers payment plans or other credit?
A2. Aging receivables; generally 60 days or more. This applies to any industry that extends credit. If delinquency/slow pay is high, credit standards need tightening. However, if delinquency/slow pay is low, but so are sales, credit policy may be too tight. It’s understandable to be lenient with a good customer who pays slow. However, banks are less likely to lend to a business that has difficulty collecting payments.

Q3. What is a common problem found in a marketing budget?
A3. Failure to be specific on marketing spend. A single line item in the profit/loss statement that says nothing more than “Marketing”, or “Advertising” is not helpful. Be specific. Create a separate line item for ALL marketing spend. If marketing is Facebook ads, public relations, pay-per-click, etc., then EACH of these should appear in the P/L.

It should be easy to spot the impact of all of last month’s marketing tactics on this month’s sales. For example, did the business run a social media ad campaign for the last two months? You should see an increase in sales to reflect that. You cannot know what is working and what is not without being able to trace changes in revenue to marketing actions. Failure to break it down is a red flag indicating both poor marketing management and poor financial management.

Q4. What is the business is growing but cash is tight? A4. If revenue is growing but the cash position is not, that could indicate any number of issues. Clearly, the business is doing more work but profitablity is the same or lower. xThat is an indication that pricing is too low, costs too high, or both. It could also mean that collections are not keeping pace with receivables. Overall, it is a scaling problem. xFor example, sales have not kept pace with added hires or inventory; the scaling has not kept to plan.

Q5. What are some signs of sloppy or possibly fraudulent accounting?A5. Minimal or no internal controls. The most common types of fraud in small businesses are rarely dramatic. They often involve manipulated expense reimbursements, fraudulent vendor payments, cash skimming, or payroll irregularities. These behaviors typically develop gradually and can go undetected for months or even years, simply because no one is actively looking for them.

The businesses most at risk are often those that have never formally reviewed their internal controls. Not necessarily because they have experienced problems, but because nothing has happened to raise concerns.

Q6. What are some steps investors/buyers can take to not miss these red flags?
A6. Get familiar with benchmarks in your industry and in your area. For example, there are average profitability margins for plumbing companies in the Chicago area with $500,000 – $1 million in sales. Compare your business with the benchmarks, and find out why the business underperforms or over performs. Bizminer provides those benchmarks.

Better Financial Controls

Small and medium-sized businesses can implement a variety of internal financial controls to prevent fraud, reduce errors, and protect their cash flow. Many are relatively inexpensive and don’t require hiring additional employees.

Check out these 10 practical examples:

Separate Financial Responsibilities: Avoid having one employee control every step of a financial transaction. For example, the person who approves vendor payments should not be the same person who issues checks or reconciles bank statements.
Require Approval for Expenses: Establish spending limits that require management approval. For example, purchases over $1,000 might require a manager’s authorization, while purchases over $5,000 require the owner’s approval.
Reconcile Bank Statements Monthly: Have someone who does not handle daily payments review bank statements and compare them with accounting records. This can uncover unauthorized transactions, duplicate payments, and unexplained withdrawals.
Verify Vendor Invoices: Before paying an invoice, confirm that the goods or services were actually received, the price is correct, and the vendor is legitimate. Require additional verification before changing a vendor’s banking information.
Review Payroll Regularly: Check payroll records for unusual overtime, duplicate payments, employees who no longer work for the company, and unauthorized salary increases. Have a manager approve payroll before payments are issued.
Monitor Employee Expense Reimbursements: Require receipts and written explanations for business expenses. Review expense reports for duplicate receipts, unusual purchases, or expenses that appear unrelated to business activities.
Control Access to Accounting Software: Give employees access only to the financial information and functions they need. Require individual user accounts, strong passwords, and multifactor authentication. Review access whenever employees change roles or leave the company.
Conduct Regular Inventory Checks: Compare physical inventory with accounting records. Investigate unexplained shortages, damaged goods, and unusual adjustments. This is particularly important for businesses that sell products or maintain valuable equipment.
Monitor Cash Transactions: Require receipts for all cash sales, record transactions promptly, and deposit cash regularly. Have someone independent of cash handling compare sales records with bank deposits.
Review Financial Reports Monthly: Have the owner or a senior manager review income statements, balance sheets, cash flow reports, and budget variances. Investigate unusual expenses, declining profit margins, unexplained changes in cash balances, and unexpected increases in operating costs.

Three particularly important controls for smaller businesses

For businesses with only a few employees, separating every financial responsibility may be impractical. However, owners can still establish meaningful safeguards:

Owner oversight: Require the owner to review bank statements, significant payments, and monthly financial reports.
Independent review: Have an outside accountant periodically examine bank reconciliations, payroll, and expense records.
Unexpected transaction alerts: Set up bank notifications for large withdrawals, wire transfers, changes to account information, and unusual transactions.

Get rid of red flags in your business finances and get ready to sell your business or get funding for the business. If you are buying a business and need to evaluate for red flags in the finances, you will know what to look for.