Exhibit Early Warning Signs of Trouble Early Action May
Stem Losses, Save Businesses
see what is in front of one's nose requires a constant
Senior Vice President
Philip + Company Inc.
credit quality comes under increasing pressure, management
consultants specializing in turnaround and crisis management
have a veritable catbird seat from which to gain hands-on
insight into the signs and causes of underperforming and
troubled companies and their remedies.
definition of an underperforming company is a business that is
somewhere between a call from a past-due supplier and the steps
of Bankruptcy Court. A more measurable definition is a business
in which one or more of the following conditions exist:
Operating profits have been on a downward slide for five
or more consecutive quarters
Net worth is in a deficit, or the earnings trend, if
continued, will create a deficit within two to three years
After-tax earnings do not represent a reasonable return
on invested capital for the risk assumed, or earnings are below
industry levels based on other standard measures, such as sales
The business is stagnant at any level — it is not
growing, evolving, and changing over time to capture
opportunities and be successful at both the operational and
warning signs are indicators of greater trouble to come —
erosion in profits, cash flow, and equity, and the potential
loss of the business. These signs can be divided into four
categories — financial, operational, management and other.
When one or more of these symptoms exist, worsening
underperformance is almost certain to follow.
of the most obvious financial signs is surprise cash shortages
or unexpected overdrafts that culminate in a request for an
overadvance of hundreds of thousands of dollars to meet the
week's payroll. It is one thing to have advance warning of
upcoming liquidity problems, but quite another to find out on
the morning of the overadvance or to be put in a position of
determining whether this week's payroll will be met. This
indicates a complete lack of financial control of the business.
troubling financial signs include:
to Prepare Timely, Accurate Financial Reports. These
include borrowing base and other bank reports. Failure to
prepare monthly financials within five to 10 days of the end of
the month or preparing them later and later is a sure sign of
trouble. Either the company does not appreciate the value of the
information, or time is being spent torturing the numbers until
they say what the company wants.
Income and Cash Flow Budgets. Fully integrated
"three-way" budgets are fundamental to sound business
management. Swings of 20 percent or more between actual and
budgeted results or a failure to prepare budgets at all are
clear early warning signs of problems.
Renegotiated Banking Covenants. This is another sign of
a lack of financial control. It often leads to preparation of
creative borrowing base calculations or other financial reports
to respond to liquidity problems or meet banking covenants.
Drawn Credit Lines. Lines of credit that do not revolve
indicate that working capital financing has become long-term
debt or worse, equity. Some credit facilities, particularly
those of seasonal businesses, require that credit lines be
cleaned up at one or more key times during the year. A failure
to clean up these facilities as required is another indicator of
Year-End Adjustments and/or Write-Offs. Year-end
statements may include adjustments that create financial results
that vary materially from internal statements provided during
the year. Invariably, these (usually draft) year-end statements
arrive with a request to waive covenants to avoid a going
of Key Working Capital Ratios. These are often
highlighted by unfavorable trends in accounts receivable and
accounts payable days, or by unreasonably low or declining
inventory turns. They are signs of a developing systemic problem
or, particularly in the case of low inventory turns, a bad
Checks. This is a variant of working capital
deterioration indicators. To issue month-end financial
statements that do not show increasing accounts payable, a
company may issue accounts payable checks at the end of the
month but then hold them. Sometimes this is difficult to discern
if the numbers have been adequately tortured. However, a large
negative cash position on the financial statements or a credit
line that does not reconcile to the actual balance is a dead
giveaway. Stretching of accounts payable also may be highlighted
by a failure to pay statutory and fiduciary obligations on time,
including pension plan contributions or obligations to the
Internal Revenue Service (IRS).
business, as in life, one is either advancing or retreating.
Standing still is not possible. Stagnant or decreasing sales
volumes are causes for concern. One also should watch for
particularly virulent derivations of this, such as sales growth
without earnings growth, or sales growth with decreasing gross
signs of operational problems are:
Losses. These include continuing operating losses before
non-operating and extraordinary items, or losses that occur at a
rate that threaten to eliminate retained earnings within two
years. It is also important to watch for operating costs that
have been capitalized or that have been classified as
Staff Turnover. Except in unique cases, employee
turnover, absenteeism, and labor and union disputes are all red
flags. Employees at all levels are quick to sense trouble. Often
the best employees are the first to leave because their
prospects elsewhere are greatest.
Concentration. Indicated by 50 percent or more of sales
from one or a small number of customers, this also may manifest
itself as the loss or threats of the loss of key customers for
any reason. A not-so-distant cousin of this is a company's
dependence on one or two critical suppliers.
Acquisitions or New Product Launches. Acquisitions and
new products are legitimate business activities. But they also
can be last-ditch efforts of an underperforming business to
rehabilitate itself, rather than a return to fundamentals to
solve its problems.
or Nonexistent Capital Investment. When operating
performance declines or a company is undercapitalized, research
and development (R&D) expenditures or employee training are
often the first victims of budget cuts. The failure to reinvest
in a business's future can be the first step down a slippery
slope of self-destruction.
is possible to manage a business simply by monitoring its key
drivers. If senior employees do not know, understand, and track
the three or four key drivers of the business, including a
measure of cash flow, it is a sign of weakness. While more
information obviously is desirable and valuable, not knowing and
monitoring the key drivers is inexcusable.
potential signs of problems with management include:
to Take Responsibility. Blaming the company's
performance on events or circumstances outside their control
often takes the form of name-calling and finger-pointing (sales
versus manufacturing, marketing versus engineering, or everyone
versus accounting), culminating in a company designating a
sacrificial lamb rather than addressing underlying problems.
Financial Expertise. An entrepreneur who is weak on
financials but who does not hire someone with the requisite
skills can sabotage a business. This problem is seen most often
in smaller middle-market companies. Any business that is flying
without a capable financial copilot eventually will experience a
Principal. This occurs when the key executive is more
focused on outside activities, such as serving as president of
the chamber of commerce or yacht club, than on running the
business. In such cases, sons, daughters, or in-laws often have
been delegated responsibility for making decisions they are ill
equipped to make.
surprise cash shortages, unexpected litigation indicates a lack
of control. Such litigation may not be a total surprise to the
company, which may have been trying to forestall it. Likewise,
unexpected compliance audits by agencies such as the
Occupational Safety & Health Administration (OSHA), the
Environmental Protection Agency (EPA), or the IRS indicate
potential underlying problems.
signs may include:
O'Hara Syndrome. This syndrome is characterized by a naďve
belief that tomorrow will be a better day. A company may insist
that another $500,000 loan will solve its problem or that the
next new product or the next quarter will be its savior.
Disputes. Lingering shareholder disputes and the absence
of a succession strategy are signs of ineffective management —
and of greater troubles to come as management takes its eyes off
the ball to focus on such disputes.
warning signs are symptoms of some underlying disease. Like a
cough or a fever, these symptoms have underlying causes, which
are the real problems facing a company. Merely addressing a
symptom is unproductive and allows a crisis to deepen. If the
patient is to return to health, the fundamental causes must be
of the most prevalent underlying causes of distress include:
Management Information System (MIS). Napoleon
Bonaparte's observation that "war is 90 percent
information" applies to business as well. Even
less-than-competent management can stumble through if executives
have timely and meaningful information on which to make
decisions. But not even a superior management team can make
reasonable decisions in the absence of information. Indications
of inadequate MIS include:
Monthly financials delivered after the 15th of the month.
"Standard" financial reports that do not
reflect the personality of the business.
No standard cost system.
No regular (daily or weekly) reporting of the three or
four key indicators of the business.
No dynamic measurement of the results of operations and
of cash flow — in-depth budget-to-actual comparisons and
effective cash-flow management.
Management. Rightly or wrongly, management usually is
blamed for business failure. A certain amount of management
culpability can be assigned in all of the causes discussed in
this article. In addition, management sometimes is or becomes
incompetent, as in cases in which the business or market has
outgrown their capabilities.
to Use and/or Listen to Advisors. Managing middle-market
companies can be a lonely experience, especially given that
these businesses generally have less sophisticated boards of
directors than do larger enterprises. In this environment, a
failure to develop and listen to a group of advisors often
results in myopic decision making.
This is an obvious problem in start-ups and in high-growth or
acquisition environments. Like other signs and causes, it does
not stand on its own—good MIS and competent management may be
able to identify and resolve the issue.
to Stick to Knitting. Success does not always beget
success. Adding new products or acquiring up- or downstream
businesses can often lead to unsatisfactory results. This is
particularly troublesome when working capital is being used as
the source of funding for the new initiative.
Beyond a Company's Control. Some problems cannot be
blamed on management, and the incidence and significance of such
problems have increased with globalization. Right now, somewhere
in Asia an entrepreneur is taking action that will affect a
borrower in the
lender that has identified a problem and has a pretty good idea
of the cause does not have a vast array of options. The lender
can make observations to its borrower, restrict availability, or
insist that the company engage professional help. To have any
chance of resolving its problems, short of additional loan loss
provisions, the borrower must:
Denial. Taking almost any action is better than doing
nothing. Other stakeholders, including employees, will be taking
action, so the company must.
Egos and Take Responsibility. Finger pointing will not
solve the problem, and the buck stops somewhere. One also should
remember that executives who got the company into trouble most
often cannot lead it out.
Outside Specialist Help. A borrower should create a
small team of key players — which ideally includes a
turnaround consultant — to develop and lead a strategy,
freeing managers to return to running the business.
the Business, Not the Crisis. A pilot learns early that
the first thing to do in a crisis is to fly the airplane and not
to lose control while trying to solve the problem. The analogy
is apt in troubled-company scenarios.
Underlying Causes, Stage of the Crisis. This will
dictate the direction and magnitude of action required. One of
the givens on most consulting engagements is that the stated
problem is usually not the real one. This is especially true in
Financial Control. Operating troubles invariably
manifest themselves as liquidity problems, which often create
the imperative to act. As a result, managing working capital,
including preparing a rolling (daily/weekly) cash flow, is job
one. Decisions become clear when one has the power of
information. "We cannot do that" or "That
information is not available" from MIS cannot be tolerated.
the Janitor. Employees usually have better intelligence
on what is going on than does management. If management thinks
employees are unaware of problems, they are being unrealistic.
Personnel, People Issues. Invariably, people issues
contribute to a company's problems. They must be dealt with
quickly, directly, firmly, and with compassion.
and financiers of businesses obviously want to minimize their
risks. Companies give clear signals of declining performance
that predict increased trouble to come. Seeing and acting on
them early can help shareholders, lenders, and others to avoid
losses and to save otherwise viable businesses.