Early Warning Signs of Financial Distress

The Interpeak Report, October 2018 |
It is unusual for companies to suddenly become financially distressed. There are typical early warning signs that in hindsight become very obvious. This month’s Interpeak Report seeks to help businesses identify some of these early warning signs that if acknowledged and corrected, may help these businesses to avoid future financial difficulties. Please feel free to share this report with your clients or borrowers who may need the services of a restructuring advisor.

Common after every restructuring is a walk down memory lane that asks the fateful question: when did the first sign of trouble appear? While each turnaround is different, there are common themes that run through nearly every one. The following warning signs, in no particular order, describe poor business practices and activities that become glaring in importance and regrettable due to their neglect when financial insolvency becomes reality.

Poor Planning

To attract investors and lenders to invest in the business, a reasonable business plan was developed. Generally, the missing ingredient is how the plan will be properly executed and, more importantly, how it will be benchedmarked. If a company is moving the goal posts back, or simply revising the budget to reflect the new realities without first addressing what is causing these revisions, these sorts of activities are a symptom of a deeper problem that needs to be immediately addressed.

Weak Reporting

The importance of strong financial reporting can never be overemphasized. Well-constructed management reports provide valuable insight into the business’s profitability, sales visibility and costs, to name a few. Without these type of reports, businesses lack the critical tools necessary to successfully manage their challenges and leave them ill-equipped should matters worsen. The lack of good internal management reporting is a very common theme in many financially struggling companies.

Failure to Manage the Cash Flow Cycle

An insidious part of revenue growth for a company with poor cash flow cycle management is the belief the company is doing better than it actually is. Failing companies are sometimes shocked to learn that the more sales they generate the more unprofitable the business becomes. Cash can be easily locked inside the business if the cash flow cycle is not managed correctly. Moreover, unless properly understood, faulty cash flow cycle management can lead to poor decision making involving both capital investments and how the business is capitalized. This critical lack of understanding can exacerbate and even deepen the company’s financial problems.

Inadequate Cash Flow Forecasting

Unlike budgeting and planning, which often include strategic components, a rolling cash flow forecast looks over a short period of time to ensure that the business has sufficient liquidity (e.g. quick access to cash) to run its operations.

Cash strains can develop quickly when expenses appear that were not properly forecasted. Failing companies generally have inadequate cash flow forecast capabilities, which leads to the inevitable sudden cash crisis.

Under-Investment

Insufficient investment in plant, property, equipment and personnel is a strong indicator of a company facing financial difficulty. While it is tempting to defer investment in equipment and avoid pay raises when cash is short, these decisions generally have the opposite effect on cash in higher repair costs and costly employee turnover.

Final Thoughts

While the lack of cash or poor cash flow visibility are ultimately the reasons companies fail, before they reach that point there are certain early behaviors and poor management practices that provide owners, lenders and key stakeholders early indications of future financial distress. Ironically, post restructuring it is very common for businesses to institute many of the reporting and best business practices described above.
The question now is: Why wait?
Email: frank.turner@interpeakconsulting.com with any questions or comments.