Companies Exhibit Early Warning Signs of Trouble Early Action May Stem Losses, Save Businesses

"To see what is in front of one's nose requires a constant struggle."

               ~ George Orwell

Ken Philip, CMC
Senior Vice President
Philip + Company Inc.

 

 As 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.

One 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 or assets

·                    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 financial levels

Early 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.

Financial Signs

One 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.

Other troubling financial signs include:

Failure 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.

No 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.

Frequently 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.

Fully 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 capital problems.

Many 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 concern qualification.

Deterioration 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 business model.

Held 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).

Operational Signs

In 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 margin.

Other signs of operational problems are:

Operating 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 non-operating expenses.

High 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.

Customer 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.

Failed 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.

Declining 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.

 

Management Signs

It 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.

Other potential signs of problems with management include:

Failing 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.

Inadequate 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 hard landing.

Absentee 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.

Other Signs

Like 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.

Other signs may include:

Scarlett 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.

Shareholder 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.

Underlying Causes

Early 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 treated.

Some of the most prevalent underlying causes of distress include:

Inadequate 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.

Inadequate 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.

Failure 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.

Undercapitalization. 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.

Failure 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.

Circumstances 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 United States .

What to Do

A 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:

Avoid Denial. Taking almost any action is better than doing nothing. Other stakeholders, including employees, will be taking action, so the company must.

Park 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.

Get 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.

Manage 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.

Determine 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 troubled-company situations.

Get 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.

Ask 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.

Face Personnel, People Issues. Invariably, people issues contribute to a company's problems. They must be dealt with quickly, directly, firmly, and with compassion.

Minimizing Risk

Owners 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.

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