Do you know the signs of financial distress in a business?

Financial statements tell only part of the story. Investors, lenders and other stakeholders who know how to identify red flags of impending problems can protect their own financial interests. Additional due diligence may be needed to uncover these issues. For instance, stakeholders might need to talk to management, visit the company’s website and compute financial benchmarks using the company’s most recent financial statement. Here’s what to look for.

Employees who jump ship

Employee turnover — at all levels — often precedes weak financial results. One obvious reason is that company insiders are often the first to know when trouble is brewing. For example, if the plant manager’s innovative ideas are frequently denied due to lack of funds or if employees hear shareholders bickering over the company’s strategic direction, they may decide to seek greener pastures.

The reverse happens, too. If certain key people leave the company, it may cause revenue or productivity to nosedive. Given time and sufficient effort, most established companies can recover from the loss of a key person.

Another reason for high employee turnover may be layoffs. Companies that can’t meet payroll may need to shed costs and dole out pink slips.

Employee turnover can also be a vicious cycle. Top performers in an organization may respond to perceived financial problems by moving to healthier competitors. That leaves behind the weaker performers, who must train new hires on the company’s operations. Finding and training new workers can be time-consuming and costly, compounding the borrower’s financial distress.

Working capital concerns

Working capital is the difference between a company’s current assets and liabilities. Monitoring key turnover ratios can help gauge whether the company is managing its short-term assets and liabilities efficiently.

When accounts receivable turnover slows dramatically, it could signal weakened collection efforts, stale accounts or even fraud. For example, a company that’s desperate to boost revenue might solicit business with customers that have poor credit. Or one of a company’s major customers might be underperforming and it’s trickling down the supply chain.

Likewise, beware of deteriorating inventory turnover. Similar to receivables, a buildup of inventory on a borrower’s balance sheet could signal inefficient asset management. Certain product lines may be obsolete and require inventory write-offs. Or a new plant manager might overestimate the amount of buffer stock that’s needed in the warehouse. It might even forewarn of fraud or financial misstatement.

Changing market conditions 

External factors may affect a company’s financial performance, but the effects vary from company to company. For instance, some companies permanently closed when the economy shut down during the COVID-19 pandemic, while others pivoted and prospered.

Today, business performance may be adversely impacted by geopolitical pressures, rising interest rates, supply chain shortages and inflation. Stakeholders should continue to monitor financial results closely in these volatile conditions.

Extra assurance

When a company shows signs of financial distress, stakeholders should encourage management to supplement its year-end financial statements with interim reports or engage a CPA to perform targeted agreed-upon procedures. Doing so can help the company assess risk, identify problems and brainstorm corrective measures, if needed. Contact us for more information.

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