When you’re running a business, the ultimate sign of financial distress is usually running out of cash – you just don’t have any money left. However, even though it seems obvious, running out of cash is almost always a symptom and not a cause of business failure. In this article, I outline a few warning signs that financial trouble is nearby (or that’s it has already started). I’ll start by identifying a few telling symptoms, and eventually go down to the typical root causes of financial distress. The key, like any illness, is to catch the symptoms early, so that you can begin to identify the causes.
1) You’re struggling to be profitable. I realize in advance that this is very obvious. Yet, in a market where it is easy to raise capital, this is not always an incredibly clear one-- it is sometimes lost on even talented business people. No matter what anyone claims, an unprofitable business is, by definition, a business at risk. When there isn’t a clear path to profitability, the business is forced to raise money outside of itself, which opens up an entirely different world of risk. The business relies, not on itself, but on others.
2) Your margins are slipping (gross or net). A margin is taking a profit number and dividing it by sales. Gross profit margin (gross profit divided by sales), usually measures a company’s ability to manage its most important costs. Margins are always expressed as cents on every sales dollar. Net profit margin is a company’s net profit divided by its sales. Often, the net profit margin of a company is far more important than the amount of dollars in profit that a company is earning. This is because net profit margin is typically an indicator of how profitable a company will be as it grows. In my experience, even financial professionals do not put in enough time into understanding margin performance.
3) Your sales are stagnant or decreasing. Again, this is an obvious one, but healthy businesses grow. Like the biology of plants, something is either growing or dying. Sales dollars are used to pay for expenses, so there is a clear financial impact of not having as much sales money available to pay for expenses; however, the very dangerous part of sales stagnation or decline is that it usually indicates a lack of customer acceptance, which is key to any business. There is no better barometer of market/customer acceptance than revenue
4) Your rate of sales growth is declining. This is something to watch out for, and it’s a fairly subtle point. Even if your sales are increasing, you have to keep an eye on the rate of growth. Is your sales percent change higher, year over year, for this year, than it was last year? If not, it may be a symptom of financial issues. One very important note: it’s natural for companies, as they grow bigger, to start seeing their rate of sales growth go down. It’s much easier to “double” your sales when you had $1000 in revenue last year than it is when you had $100,000,000 last year. Still, it’s important to keep your eyes on the rate of growth.
5) You are profitable, but do not have positive cash flow from operations. It would take too many words to explain this in full, but it is very possible to be profitable and still not be generating positive cash flow. At some point, all businesses need a good accountant—one who is experienced in financial analysis and who can help you navigate through this issue of liquidity. Not all accountants are good at financial analysis, so this may take some digging on your end.
6) Renewal sales, inbound leads, or other metrics related to market acceptance are flat-lining. Most companies live and die on the stickiness of their product— i.e., repeat business and word of mouth. The market tends to be efficient, and customers tend to make good purchasing decisions. A company should have metrics by which it can evaluate how solid its customer relationships are. Most businesses have unique ways to measure the stickiness of customer base – renewals, repeat business, Yelp ratings. When these metrics start sliding, it will eventually have serious financial consequences and will likely manifest itself in some of the symptoms listed above.
7) Your employee turnover is getting higher. While it’s true that each industry will have specific challenges and rates of employee retention, significant changes in employee turnover tend to be an early warning sign that a business is in trouble. Sometimes this is measured, erroneously, by changes in key personnel. I’m more interested in overall employee retention changes.
8) The product or service you offer is decreasing in quality. You need objective metrics to measure the quality of your product. This is very closely related to point number 6. Ultimately, marketing, public relations, and “buzz” can only help you to a certain extent. The product’s quality should speak for itself. You want to be offering a product whose quality is so high that, in order to lose, you have to virtually everything else wrong. This must be tracked internally by the company, not just by customers.
9) Your office/workspace/headquarters looks messy. In my previous consulting career, I got to the point where I could walk into a business, and pretty much know immediately if it was doing well or not. Are the bathrooms clean, are the floors clean, what’s the condition of the paint? Do people care about the company? You’ll be able to tell by how they treat their workspace.