I have recently pointed out that one of the warning signs that a business is facing issues is when core revenue, ie revenue from the main business lines, is down but profit is up.

Why the combination? Why not simply flag a drop in core revenue? Because it is normal for revenue to fluctuate – especially in a challenging economy. But if revenues go down and profit goes up, it means the business has miraculously had a major increase in non-core revenue or, worse, has made large cuts to expenses.
Large jumps in non-core revenue are rarely sustainable. They usually come from either re-valuing assets, an exercise that does not affect cash flow nor is it recurring, or from the sale of an asset at a price higher than it was held on the books, which helps cash flow but is non-recurring and may reduce income-generating assets.

On the expense side you have actual cash expenses that are reduced, usually employee compensation or number of employees, but this can also include things such as rent. These have a positive cash-flow effect but are limited in the number of times they can be done, not to mention that it can affect revenue generation by losing employees or reducing morale.
The red flag is when non-cash expenses change drastically, such as depreciation, amortisation and impairment charges. This is a red flag because it is relatively easy to massage these numbers, plus it has no impact on cash flow. Continue reading →