Financial statements provide valuable insights into a company’s economic performance, aiding managers, lenders, and investors in their evaluations. However, they offer only a partial view and may fail to highlight financial distress until it becomes critical, particularly for companies that issue reports only once a year. To stay ahead, it’s essential to recognize these five common warning signs that a company might be facing financial difficulties:
1. Financial reporting delays. Late financial statements may signal unqualified accounting personnel, inadequate recordkeeping, or even fraud. Sometimes, the company’s controller or CFO may be reluctant to show uninformed owners how severe the situation has become. Or management may procrastinate over concerns that lenders will call loans or refuse to waive covenant violations.
2. High employee turnover. Employees, who are often the first to recognize problems, may abandon ship when they’re aware of financial distress. In particular, stock options motivate employees to leave the company before their options lose additional value. Turnover is especially problematic when it involves hard-to-replace executives because it can have a ripple effect that lowers the morale for the remaining staff.
3. Fixed asset auctions. Healthy companies routinely invest in new equipment and upgrades. However, struggling companies may sell fixed assets to boost operating cash flow. Auctions bridge temporary cash shortages and help purge a company of idle or outdated equipment. Unfortunately, they don’t always work as intended. Auctioning equipment compromises a company’s ability to generate future income, especially if management liquidates valuable operating assets at fire-sale prices.
4. Questionable accounting practices. When business owners try to hide deteriorating performance, they often devise creative accounting strategies to increase sales and profits. For example, a company may engage in above- or below-market, related-party transactions. Management might also make aggressive accounting estimates to overstate asset values or earnings.
5. Frequent or haphazard loan requests. Maxed-out credit lines and frequent new loan applications may indicate something’s awry. Each time a company asks for loan proceeds, it should have a detailed plan for how management will use the funds. When cash is tight and loan requests are denied, stressed business owners may become desperate. For instance, they might take on debt with unfavorable terms or use their personal credit cards to fund their companies’ working capital needs.
Be on the lookout
Company insiders typically have an advantage in detecting signs of financial distress earlier than external stakeholders. However, proactive due diligence can bridge this gap. If you have a financial stake in a company, consider monitoring recent developments through news reports, following the company and its key employees on social media, scheduling quarterly meetings with management, and visiting publicly accessible facilities like retail stores or job sites. Additionally, lenders or franchisors concerned about declining performance might request an agreed-upon procedures engagement to identify potential weaknesses and suggest improvements. Contact an Axley & Rode advisor for any further questions.
