The hidden messages in financial statements: red flags and warning signs

Financial statements are like a language—one that speaks to the health, prospects, and operations of a business. Yet, beneath the seemingly straightforward balance sheets, income statements, and cash flow reports lie hidden messages that reveal much more than meets the eye.

Investors, analysts, and stakeholders need to be able to decipher these underlying clues, especially when red flags and warning signs lurk just beneath the surface. Let me take this opportunity to illuminate some of these red flags in financial statements to my cherished, and respectable readers of my article(s).

What is the issue?

Financial statements are intended to provide an accurate and transparent view of a company’s financial health, yet they often conceal critical information that can mislead stakeholders like you.

While these statements may appear straightforward, hidden red flags and warning signs—such as revenue manipulation, rising debt levels, inconsistent cash flows, and changes in accounting policies—can obscure a company’s true financial position. The inability of investors, regulators, and financial analysts to detect these subtle yet significant signals can lead to poor decision-making, financial losses, and even corporate scandals.

For instance, Ghana adopted International Financial Accounting Standards (IFRS) in 2007 to address issues relating to insufficient disclosures in financial reports, and to promote greater transparency, international conformity – to aid existing and potential investor decision-making (Boateng, Arhin & Afful,2014). Nonetheless, over ten (10) years of adopting IFRS, Ghana have suffered a series of corporate failures due to lack of transparency and inadequate disclosures.

Between 2017 and 2019, the Bank of Ghana revoked the licenses of several banks and financial institutions, citing insolvency, poor corporate governance, and systemic risks. While many were shocked by the collapse of these seemingly thriving institutions, the truth is that the warning signs were always there—hidden within their financial statements. The problem, therefore, lies in identifying and interpreting these concealed indicators to ensure the reliability of financial reporting and protect the interests of all stakeholders.

The Facade of Numbers

Financial statements provide an array of performance indicators, offering insights into profitability, liquidity, and solvency. But while most businesses present this information in an organized and professional manner, some intentionally or inadvertently hide distress signals. These warning signs could indicate potential financial distress, fraudulent activities, or management inefficiencies.

Warning Signs and Red flags:

Revenue Manipulation: The First Red Flag

A company’s revenue is often seen as the most significant indicator of success. However, not all revenue is created equal. A sharp increase in revenue that is not accompanied by corresponding growth in cash flow can be a cause for concern. This discrepancy suggests that the company might be recording sales without actual cash being received—often a red flag that points to aggressive revenue recognition or even fraud.

Take, for instance, a company that extends its credit terms to customers to inflate its sales figures at the end of a financial period. Such practices can inflate revenue numbers, but a deeper look at the accounts receivable (debtor’s ledger) could reveal that a significant portion of these sales may never translate into actual cash flow.

Sudden Increase in Debt: A Subtle Signal of Distress

One hidden signal that often escapes the eye of the untrained(non-accounting) reader is a sudden rise in a company’s debt level. A business can boost its short-term liquidity by borrowing heavily, giving the illusion of stability. However, without a corresponding rise in assets or productive investments, this debt can lead to long-term financial strain.

For instance, if a company’s debt-to-equity ratio skyrockets within a short period, it could signal that the company is struggling to generate sufficient internal cash flow and is using debt as a quick fix. Stakeholders should be wary of such practices, as they often precede financial instability.

Unexplained Changes in Accounting Policies

While accounting standards allow some flexibility in how businesses report their financials, frequent and unexplained changes in accounting methods can be a significant red flag. For example, changes in depreciation methods, asset valuation practices, or revenue recognition techniques should be scrutinized closely. These changes may be an attempt by management to manipulate earnings or hide operational weaknesses.

A case in point is when a company switches from the First-In, First-Out (FIFO) method to the Last-In, First-Out (LIFO) method of inventory accounting. If this change is not well justified, it may be an attempt to lower taxable income by increasing the cost of goods sold.

Inconsistent Cash Flows

Cash is king in the financial world. A company’s profits may be high, but if cash flow from operating activities does not align with its profitability, this discrepancy should raise eyebrows. A growing business should naturally see an increase in cash from operations; however, if cash flows are declining while profits are rising, this could suggest that profits are being propped up by non-cash items like unrealized gains or deferred revenue.

For instance, a company may boast increasing profits but is consistently borrowing more to meet operational costs. This might be a sign that earnings are being exaggerated, masking the company’s inability to generate enough cash.

In 2017- 2019 banking crises, one red flag was the significant mismatch between reported profits and actual cash flow. While profits were being reported, many banks were suffering from liquidity shortages—indicating that they were recognizing revenue from loans that were not being repaid by related parties and cronies. The banking crisis demonstrated how overstatement of income, particularly from non-performing loans (NPLs), distorted the true financial position of these institutions.

Unusually High or Low Provisions for Bad Debts

In some cases, businesses may understate their provisions for bad debts to inflate earnings. Provisions are estimates of the percentage of receivables(debtors) that a company expects will not be collected. If a company reports a rapid increase in sales, but provisions for bad debts remain stagnant or decrease, it might be understating the likelihood of default, artificially boosting its bottom line.

Conversely, an unusually high provision for bad debts could indicate that the company is experiencing significant difficulty in collecting receivables—another warning sign of financial trouble.

Operating Leases Hidden in Off-Balance-Sheet Items

One of the subtler warning signs can be found in off-balance-sheet items, such as operating leases. Companies may take advantage of certain loopholes in accounting standards to keep significant liabilities like long-term lease obligations off their balance sheets. This practice can paint an overly optimistic picture of a company’s financial health. A careful review of the notes to the financial statements, which disclose such commitments, can often reveal these hidden liabilities.

Attracting Relevant Stakeholders

Investors, auditors, and regulators alike must look beyond the numbers presented and pay close attention to these red flags. While financial statements offer a snapshot of a company’s performance, the quality of earnings and the sustainability of growth can only be understood by identifying the hidden signals within.

Stakeholders should develop a keen eye for unusual patterns—unexplained changes in accounting policies, sudden increases in debt, or mismatched cash flows. By so doing, you can uncover the hidden information that often leads to more critical questions: Is the company genuinely profitable? Can it sustain growth, or is it manipulating figures to attract investors and creditors?

Conclusion: The Power of Skepticism

In a world where corporate scandals and financial frauds can quickly erode value, the importance of understanding financial red flags cannot be overstated. A skeptical eye combined with an informed understanding of financial statements can prevent costly mistakes for investors and lenders. It’s not just about reading the numbers; it’s about interpreting the hidden messages behind them.

By learning to spot these warning signs early, stakeholders can safeguard themselves against potential risks, ensuring that they make more informed decisions in today’s increasingly complex financial landscape.

Enoch is a Chartered Accountant / Certified Banker with a deep passion for accounting, banking, and governance. His expertise spans both education and practice reflecting a commitment to research and knowledge sharing. He can be reached via [email protected]). Contact: +233244201383.