Sabitri always had a dream of running her small business of Dhakai Sarees. The dhakai jamdani saree with its origin in Bangladesh has intricate thread work that is liked by her customers. The business began well and soon she began receiving multiple orders. Sabitri could generate profits but was still far away from reaching break-even as the orders which she received from other states required packaging and couriering which was expensive and began incurring losses. This strained her savings to buy new inventory due to which she could not cater to the demands and within the next few months, had to close the business.
In the above-mentioned case, Sabitri’s business had several red flags which she failed to identify. For a small business to grow it is essential to carefully analyse the financials, competitive strength, and growth potential. Here is the list of probable red flags that every business owner should look for in his/her business.
A Red flag in business is a warning and should be solved beforehand to prevent the business from closing.
Identifying the probable red flags in a Small Business
Small businesses should maintain their financial records and should look at the growth rate of revenue /income. There should be a consistent increase in revenue and income growth, however, there can be few months where the business can experience a dip but overall, there should be a consistent rise. If the revenues are highly inconsistent it should be treated as a red flag. However, there are exceptions for commodity companies’ market volatility in commodity prices.
Increasing debt-to-equity ratio
A business needs funds to operate and grow. The business is supposed to utilise the profits for the development of business. However, on most occasions, companies have to opt for debt to finance their growth plans. The high debt to equity ratio is acceptable as long as the company has enough cash flows to cushion its debt. However, if a company has a constantly increasing debt-to-equity ratio, then it is a red flag and it is financing its growth aggressively using debt. Business owners need to be careful about expenses and debt.
A high number of miscellaneous expenses
Businesses when new, spend excessively in beautifying the infrastructure, if these expenses are of high value, it should be recognised as a red flag that might cash-strip the business.
Poor cash flow
A business can be profitable and yet can have poor cash flows. When cash does not flow into the business, it means that receivables are not collected properly. It is a matter of concern for the investors as they might think revenue is being exaggerated or the business is finding it difficult to pay loans. If the cash flow of a business is low then it might result in a cash crunch. Businesses here need to understand that if the cash flow is due to the poor collection, then they should communicate the same to customers and push for payment.
In efforts to increase product lines, a business will bring in new inventory. But if the products are not selling which means it will result in piling up of inventory. The longer a product remains on the shelves the bigger risk it holds for its obsoletion. It is easier to spot this from the financial statements by using the ending inventory number from the previous year’s balance sheet. This amount is divided by the current year’s sales. If the number is more than it has been in previous years, something must be done to get products moving at a swifter pace.
Disposal of fixed assets
Old equipment and machine that is not being utilised or has permanently stopped working should be sold, however not to pay down debts or to fulfill short-term expenses as it might hurt a business’s future operating expenses. To make sure gains, losses, and disposals are being used correctly, it is wise to examine the income and balance sheets.
Repeated complaints about products or processes can be a red flag, as it might cause dissatisfaction among customers and lower the demand. Businesses should immediately try to resolve the problem behind it to ensure no more complaints arise in the future.