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March 7, 2011 Profit Motives

On the lookout | Five warning signs your business is beginning to falter and could fail

By Alison Hinson

“Profit motives” is a new Mainebiz column about financial management by small business finance coach Alison Hinson that will appear six times per year.

Companies go out of business for many reasons, but the end result is the same: The company shuts its doors and stops providing much-needed services and paychecks. Although the “going out of business” process can happen quickly, the issues that caused the company to fail are usually apparent months or years earlier. Understanding and interpreting information in your financial statements can give you an early warning that something is going wrong.

The following is a list of signs that your company is starting to fail and where to find red flags.

1. All of your eggs are in one basket

It’s tempting to ease off on sales and marketing when your company is doing well. Why push so hard when you have a steady pipeline of work? However, your pipeline might not be as full as you think if much of your revenue is concentrated among a few customers.

Find your red flag by looking at a list of your customers and the percent of overall revenue they contribute to your company (use Quickbooks’ income by customer summary report, modified to show percentages by customer). If any one customer is providing more than 10% of your overall revenue, it’s time to start diversifying so that one customer does not have a significant impact on the long-term sustainability of your business.

2. Your line of credit is your major source of cash

Another sign that your business is starting to fail is that the outstanding balance on your line of credit keeps hovering near the top of your limit. Lines of credit are usually set up to augment cash flow, not to be the permanent source of cash. Staying near the upper limit without paying it down is a sign you’re not generating enough operating cash to keep your company alive.

The red flag for this warning sign is found on your lending statement. There are many reasons for a lack of cash, but the primary ones are listed below as additional warning signs.

3. Your customers are strangling your cash flow

Companies go out of business when they run out of cash — if you are not collecting on your accounts receivable, your ongoing source of cash has dried up. In general, companies are taking longer to pay and it is not unusual to wait an average of 78 days to receive payment on 30-day invoices. Delays in cash receipts can put you in a tight cash flow position. Watching your accounts receivable outstanding amounts drift from 30 to 60 to 90 days is a sign that you may be out of cash (and business) soon.

The red flag for this warning sign is found in your list of outstanding accounts receivable (Quickbooks’ A/R aging summary report). Begin following up with companies more than 30 days outstanding to find out when (or if) you will be paid. Consider using the services of a factoring agent to help speed up your cash receipts going forward.

4. Your COGS is too high

The expenses included in your cost of goods sold can make or break your company. If your COGS is too high, you are not making a profitable product, you are either priced too low or your costs are too high. The end result is that your COGS has increased to a point that it is not providing the cash you need to pay your administrative expenses.

Review your COGS percentage for the last three years and see if this number is rising (Quickbooks’ profit and loss report, modified to show percentage of revenue). If so, look at raising prices, work with your suppliers to decrease expenses or look for efficiencies in your workplace.

5. Your administrative expenses are causing a long, slow death

It’s easy for administrative expenses to increase, but the end result is the same as if your COGS is too high: You will slowly strangle the company. If your administrative expenses have increased without a corresponding decrease in your COGS, your overall expenses have gone up. This could happen if you moved to a more expensive location or bought a new piece of equipment that is not generating enough gross profit to cover its loan amount and other related costs.

Review your administrative percentage for the last three years and see if this number is rising (Quickbooks’ profit and loss report, modified to show percentage of revenue). If so, start strategizing ways to decrease administrative expenses so your bottom line stays healthy.

The answers to these warning signs generally aren’t found with a quick glance at your income statement, so dig a little deeper to find the red flags. Know what number to look for, respond appropriately and plan for a long future as a business owner.

 

Alison Hinson, owner of Alison Hinson MBA, LLC, can be reached at alison@alisonhinsonMBA.com.

 

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