The last 14 months have presented a challenging landscape for individuals and businesses alike. While 2019 was generally strong, 2020 was marred by an unprecedented global economic collapse, as the COVID-19 pandemic brought 10 years of economic expansion in the United States to a screeching halt. The impact of COVID-19 has been dramatic in scale and scope and something the world has not seen since the Great Depression or the Spanish Flu Pandemic of 1918.1
In March 2020, as COVID-19 started to spread throughout the U.S., states implemented distancing strategies to slow the contagion, including closing schools and non-essential businesses, implementing restrictions on public gatherings, and, ultimately, issuing shelter-in-place orders. These containment measures led to a severe contraction in economic activity, as businesses and schools switched to remote work or shut down operations and consumers canceled, restricted or redirected their spending.
Monetary and financial market policy reacted forcefully and quickly to the emerging crisis. The Federal Reserve dropped interest rates to 0% to 0.25% and announced the resumption of (unlimited) large-scale asset purchases, swelling the size of the federal balance sheet. In addition, Congress passed a suite of budgetary acts to shield families and businesses. Cumulatively, these acts led to a ballooning of budget deficits in the short-term, raising debt levels by more than 20% of gross domestic product.2
As all this was going on, many small and mid-sized middle-market companies modified their loan agreements with their lenders, which resulted in either deferred payments, loan covenant forbearance, extension of loan terms and, in many cases, over-formula borrowings. Businesses also reached similar relief agreements with their landlords, deferring lease payments and/or extending lease terms. In addition, many businesses took advantage of government sponsored loans and grants, which provided much needed working capital for payrolls, rents and other operating expenses.
While these various forms of relief allowed businesses to survive the onslaught of economic turmoil, in many ways, the relief masked many of the underlying issues that can undermine a company’s performance. Providing nearly free money to businesses can perpetuate bad habits, which can manifest as early warning signs of a struggling business. In order to take corrective action, the warning signs must be identified.
The warning signs are there, buried in the numbers, and if you know what to look for, you will be able to identify and correct the key issues negatively impacting a business. When I look at a company’s balance sheet, I tend to focus on a few key areas first.
Working Capital Management
First, aside from cash balances, take a close look at the working capital accounts. Managing working capital is the lifeblood of an organization and is the key to achieving a solid balance between growth, profitability and liquidity. Working capital management includes activities such as debt management, revenue collection, payments to suppliers and inventory management. How working capital is generated and utilized greatly influences a company’s liquidity — which measures a company’s ability to pay off its bills when they are due — and/or how easily and effectively a company can access the money it needs to cover its debts.
There is a built-in relationship between the activity of a business and its main working capital accounts. Warning signs start to appear when these relationships begin to change. For example:
- Increasing accounts receivable without a corresponding increase in revenues could indicate poor credit policies and a lack of collection follow-up. Decreasing accounts receivable could be a result of decreasing sales.
- Increasing inventories could indicate obsolete inventories or inadequate inventory controls and purchasing protocols. Decreasing inventory levels could be the result of decreasing orders or a lack of willingness by suppliers to provide goods to the company. If orders are not decreasing, low inventory levels increase the likelihood of not fulfilling future orders.
- Increasing vendor payables without a corresponding increase in sales activity could indicate an inability to pay vendors in a timely manner, and decreases in accounts payable may indicate inadequate cash controls and disbursement policies.
Next, I also look at changes in fixed assets. My concerns typically center on why an asset was purchased, what kind of return on investment is expected and how that asset was financed. The warning signs are dependent on the answers to these questions. Warning signs may include poor cash controls or a lack of a robust capital expenditure policy. Any investments in assets that do not generate revenue or reduce costs should be highly scrutinized.
Next, I look at a company’s current and long-term debt and do a quick debt-to-equity calculation to see whether or not it is highly leveraged in comparison with industry averages. Borrowing is a great way to leverage the equity of the company, but too much debt can easily choke a company’s growth plan. In addition, the company’s equity and retained earnings are on the balance sheet. When examining this section, you are looking for ongoing losses, but you also should look for distributions or dividends that can be a drain on a company’s cash.
Switching over to the company’s income statement, I start with the basics: Are they losing money? Using the relationship between revenues and costs, I look for unexpected changes in key cost drivers. Decreasing margins, despite an increase in sales, should always be analyzed. Whether it be material, labor or overhead, you are looking for consistent cost of sales percentages. Material negative variances are the warning signs that need to be investigated. Fixed operating expenses, including selling, general and administrative expenses, also can contain some key warning signs. I look at the ratio of these expenses to revenues and compare them to prior year results, budgets, projections (if available) and/or industry averages. By comparing fixed operating expenses to these benchmarks, you will quickly see which fixed operating expenses need to be reviewed.
In addition to income statements, cash flow statements provide good information about how a company is financing its operations and a background on the working capital changes discussed earlier in this article. These statements also provide information on changes in fixed assets as well as debt borrowings and repayments, linking the activity of both the income statement and balance sheet.
KPIs, Metrics & Ratios
Truth be told, sometimes a company’s numbers look normal or not materially out of line with prior years’ results, meaning the warning signs don’t jump off the page. In such instances, another way to make sure there are no early warning signs is to review key performance indicators (KPIs), operating metrics and ratios.
To start, conduct a simple trend analysis to see if these metrics are improving or getting worse over time. In order to see how the company compares with its competitors, it is best to benchmark these same metrics and ratios against industry averages. In my profession, we typically focus on our clients’ KPIs and if it does not have them or has very few, we calculate metrics that we view as relevant and critical to the business. For financially stressed companies, make sure you look at metrics that focus on working capital as well as operations, including:
- Days sales outstanding that are increasing and higher than industry averages
- Inventory turnover that is decreasing and lower than industry averages
- Days payable outstanding that are increasing over time as revolving lines of credit reach their borrowing limits
Many factors go into recognizing and assessing early warning signs. I want to emphasize how important it is to know the business, the industry and how the company is impacted by world events. Sometimes warning signs exist outside of the company itself and may include:
- Customer concentration: A broader base can smooth out any individual customer’s volume fluctuations.
- Single sourced raw material supplier: This can be problematic due to tariff issues or disruptions to shipping channels.
- Supply chain issues with critical suppliers: Think about the semi-conductor shortage with which the automobile industry is dealing.
- How sensitive is the company to changes in global commodity prices for oil, steel, energy and similar items?
Remember, the earlier you recognize there is a problem, the easier it is to implement corrective action. Looking for early warning signs should be part of your company culture and integrated into every aspect of the business.
Lubik, Thomas A. and Waddell, Sonya R., “COVID-19 and the U.S. Economy,” Federal Reserve Bank of Richmond, March 31, 2020.
Organization of Economic Co-operation and Development, “OECD Economic Forecast Summary: United States 2020,” http://www.oecd.org/economy/united-states-economic-snapshot/, July 2020.
Keith Chulumovich, CPA, is a managing director at O’Keefe, a strategic and financial advisory firm. Chulumovich specializes in strategic and operational planning, business analysis and financial reporting, process improvement, turnaround/profitability improvement initiatives, and management of operating budget and forecast planning cycles.