How to Spot The Early Warning Signs of a Troubled Company in a Turbulent Economy

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.

Warning Signs

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.

Working Capital Management

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.

KPIs, Metrics & 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?