When an organization is not performing in a way that will support the organization for the long term, you can see the first red flags in the financial statement.
The problem for many board members, however, is that it’s hard to know where to look for red flags or how to interpret the financial reports in order to identify what may be a growing concern. Knowing where to look, or what to look for, are the most important considerations, and a board’s diligence in identifying, monitoring, and responding to key financial and operational indicators will determine whether or not an organization will meet its mission.
An early and more obvious red flag is month over month, or year over year, negative profit margins. Continuous financial losses will result in the eventual loss of any excess cash, savings, or endowment. Determining how long an organization can sustain negative operations is critical.
A second red flag is the absence of a financial dashboard; often a 1-page summary that highlights the most important data and information from the financial report. The dashboard should include benchmarks or ranges for each financial ratio. Sometimes those benchmarks are dictated by a bond or bank covenant, your audit partner can also provide appropriate benchmarks, and senior living organizations can look to the CARF guide for appropriate ratio benchmarks. The most important ratios to consider are those that provide you with your profitability margin, liquidity, and capital structure ratios to understand debt service coverage. Most organizations regularly monitor Days Cash on Hand, Net Operating Margin, Days in Accounts Receivable, and Debt Service Coverage Ratio. When any of these financial ratios are not meeting the benchmark, a red flag should be raised.
A third red flag is declining census or ongoing occupancy issues; deteriorating admissions and ongoing census challenges. Declining census or open apartments/beds/group homes always result in reduced revenue, ultimately resulting in operational deficits.
“If you find the words “going concern” then it’s time to pull the fire alarm because that means the auditors are worried about your organization’s viability in the next 12 months!”
The auditor’s opinion letter can offer an obvious red flag. If you find the words “going concern” then it’s time to pull the fire alarm because that means the auditors are worried about your organization’s viability in the next 12 months! A yellow flag from your auditor’s letter usually occurs somewhere in the third or fourth paragraph that might say something like “except for . . .” or “it was not possible to…” which means the auditor is giving a qualified opinion. It may amount to little more than a technical provision, but it could suggest deeper problems in the organization. In rare instances, it can be a “disclaimer of opinion,” meaning the record keeping is so bad that the auditor is unable to give an opinion at all. Read the opinion letter carefully, and beware of the word “except.”
Another red flag for a board is lawsuits or potential lawsuits. A good risk management program identifies potential legal challenges, often resulting from accidental falls, medication, or other errors in care, and any other issues of this nature that could result in potential damages should regularly be reported to the board. Many MHS Association members participate in the FSA Risk Management and Compliance programs, providing reliable consulting support in these areas which helps in avoiding these kinds of problems.
With the current labor shortages, another red flag is high employee turnover. We know that good work environments greatly increase employee engagement and retention. Management that does not understand the importance of good leadership and how to create positive employee cultures will have greater financial loss as a result of that turnover and will often have to rely on the high cost of staffing agencies.
It often takes fresh eyes to identify a red flag. This can be unfortunate when it’s a new CEO or a new board member who is in the awkward position of pointing out concerns that have been overlooked. It’s not easy to ask probing questions, but that’s the board’s job! There’s a big difference in asking questions to better understand information, than digging into operational issues. However, at times, digging into operational issues may be warranted if there are enough red flags or a lack of trust.
Governance work is not for the faint of heart. It takes true care and diligence to ensure that a board is appropriately monitoring the ongoing health of an organization. It is your role as a board member to ensure your organization is living up to its mission and has its eye on the vision for the future for years to come.