Financial literacy is a very interesting subject. Throughout my working life, and especially after I retired 17 years ago and went into training and mentoring, people across a wide variety of groups – undergraduates, entrepreneurs, independent directors – have kept telling me, “Of course I know I should be knowledgeable about Finance. Please give me the book or books that I can read and refer to for this purpose”.

So, directors do know that awareness of the financial aspects of a business is a boardroom necessity. No problem there. The issue is ‘where to find the knowledge’.

I will give you the answer I give to everyone who has asked me this question. The knowledge is context-sensitive, and is contained in 30 or 40 nuggets, each of which addresses each of the contexts you may find yourself in. There is no one-size-fits-all answer, no single-dose panacea.

In this blog, I would like to give you my perspectives on one such nugget: Getting early warning signals of financial sickness.

Financial Sickness, and How to See It Coming

I’m making a fundamental assumption to begin with, that you understand financial statements, you know how to read the Profit & Loss Account, the Balance Sheet and the Cash Flow Statement. You know what these reports contain, but you wonder if the figures cleverly hide an impending disaster, a possible financial failure ahead. What should you look at, what questions should you ask, to know if such a threat exists?

I will give you some simple guidelines to either spot sickness or to assure yourself that the business is healthy.

A) Compare the Net cash flow from Operations (CFO) in the Cash Flow Statement with the Profit after Tax in the P&L Account (PAT). Is CFO significantly lower than PAT? Worse, is CFO negative though PAT is positive?

1. If yes, get into the item-wise details of the difference.
2. If the negatives are in Working Capital changes, and a large part of the profit is blocked in the increase of receivables or inventories, calculate the relevant ratios and see if they are OK. If inventory turnover ratio has gone down substantially, find out why.
3. An innocuous item in Current Assets is “Other Current Assets”. If this has gone up a lot, get the details.
4. If the negatives are some non-cash items, which have boosted PAT but not CFO, get the list and make sure they are reasonable.

B) Compare the unaudited financials given to you for the previous quarter and year-to-date with the final figures for the year. Identify items that have changed dramatically.

1. For example, Sales may have been averaging 100 for the last nine months, and you see the latest quarter figure is 150. Ask for explanations for the leap.
2. If the increase is coupled with a big increase in Receivables, and if sales are to trade partners and not end customers, do some serious search.

I have a word limitation, so I will stop here. But I hope I have tickled your curiosity!