Buying a Business? Watch Out for These Financial Red Flags
Written by – Arunima Motiwala
Buying a business can be an exhilarating opportunity, whether you’re looking to expand your portfolio, enter a new market, or breathe new life into a struggling company. However, not every business is a golden opportunity. Some come with hidden financial pitfalls that can turn your dream investment into a costly mistake. Even well-known companies have fallen victim to financial mismanagement, industry shifts, and undisclosed liabilities. To help you navigate this complex process, here are the key financial red flags to watch out for, complete with real-world examples and actionable insights.
- Hidden Debt: What’s beneath the surface?
One of the major risks of buying a business is hidden liabilities. They can include outstanding loans, tax debts, unpaid suppliers, or even legal issues. Financial statements are not always accurate, particularly if the owner has left some debts unreported.
Kingfisher Airlines shut down in 2012 after having ₹7,000 crore of hidden debt that was not reported in its financial statements. These liabilities were revealed and the airline had to shut down.
To avoid a similar situation, it is recommended to check bank statements, credit reports and legal documents alongside financial statements. You may be walking straight into a pit of financial losses if the business has no disclosed financial problems.
- Declining Revenue and Shrinking Margins: A double warning sign
A business with declining revenue or shrinking profit margins is not necessarily a failure but this needs to be looked at further. Are these issues temporary or do they point to more structural issues?
Videocon Industries was once a market leader with 25% share, but by 2018 its revenue had dropped by 60% due to competition and mismanagement. Cost inflation and shrinking margins led to bankruptcy, with debts greater than ₹30,000 crore.
If you are planning to buy a business with decreasing sales or declining profits, you should check on the financial statements of the company for the last 3-5 years, costs, and trends in the market. It is a red flag if there is negative trend with no clear turnaround strategy.
- Cash Flow Issues: Profitable on paper, but can it pay the bills?
Without proper cash flow management, a business can show profits and yet struggle to meet its day-to day expenses. This is particularly the case in markets where customers delay payments, while expenses such as rent, and payroll are due immediately.
Jet Airways made profits but could not cover the costs of suppliers and employees. By 2019 it had filed for bankruptcy with debts more than ₹8,000 crore, after suffering severe cash flow problems.
Before buying a business, review cash flow statements and accounts receivable. The reliance on short term loans to exist is a sign of warning.
- Weak Working Capital: Can the business sustain daily operations?
Working capital, which is the difference between current assets and current liabilities, is an important determinant of whether a company can meet its day-to-day expenses. This is a clear sign of a more serious financial problem if a company is unable to meet its short-term liabilities.
In 2019, Reliance Communications (RCom) defaulted on ₹46,000 crore of debt because of a working capital crunch, even though it had strong revenue. It was forced into insolvency because it was unable to meet its short-term obligations.
Examine the liquidity of the company and the turnover of inventories. It can choke a successful business if there is no working capital.
- A Dying Industry: Does this business have a future?
Even a well-run business will struggle if its industry is in decline. It is impossible to sustain long term success even if the operations are very efficient when there is declining demand.
HMT Watches, which once had 70 percent of the market, did not manage to compete with Titan and Casio. It shut down its manufacturing units by 2016 as there was no demand for traditional watches.
If an industry is shrinking, ask: Are competitors exiting the space? Can the business pivot? Are new technologies replacing traditional offerings? If the market itself is vanishing, the business will likely follow.
- Poor Record-Keeping: A Sign of Deeper Issues
Disorder in financial records may be an indication of poor performance, mismanagement or even fraud. It is a major red flag if the seller is not able to provide clear and verifiable financials.
In 2009, Satyam’s founder admitted to inflating revenue by ₹7,000 crore and fabricating cash reserves of ₹5,040 crore. The scandal led to the collapse of one of India’s largest IT companies.
There are audited financial statements, tax filings, and clear accounting records that you should ask for before buying a business. If the books are a mess, it means the business is as well.
Final Thoughts: Make sure you’re buying potential, not problems
Buying a business isn’t just about getting a good price, it is about ensuring long-term success. Even large and famous companies have gone bankrupt due to financial mismanagement, changes in the business environment or unknown risks. The success of any acquisition is down to due diligence: break down financial statements, check on the working capital and cash flow and study the industry.
Take your time. A good deal will stand up to scrutiny, but a risky one will show its flaws. You can make an informed decision and be on your way to success by watching out for these financial red flags. What matters is not so much to acquire a business as to acquire a business with potential.