Some 60,000 businesses fail every year, but more than four times that number are in trouble at any given time. A prosperous economy often masks problems, particularly in middle-market companies. During these times, creditors and lenders are more tolerant of marginal performance.
Problems with the core enterprise are most evident, and easier to predict, if efforts are made to benchmark the debtor against others in the industry. This is not as difficult as it sounds. Both industry and company data are widely available through various public sources, including the Department of Commerce, Robert Morris Associates, 10-K filings, etc.
Heightened sensitivity to subtle changes in the operating environment can also substitute for more difficult and often more expensive quantitative techniques.
In good times, lenders must look harder for warning signs-before any downhill slide becomes manifest in the numbers. Negative surprises and sour loans can be prevented by looking past the financials to operating and market factors.
Some red flags that can indicate serious trouble ahead:
Debtor asset management practices are subpar. Accounts receivable outstanding and low inventory turnover result in excessive demands for working capital.
Cash flow is not monitored or analyzed by management, resulting in surprise calls for cash or excessive use of existing lines of credit.
Return on invested capital falls below acceptable levels. Alternative investments could yield higher returns.
Sales forecasts are consistently missed while expenses meet or exceed plan.
Capital needs and other investments are financed from working capital, dangerously reducing the liquidity of the enterprise.
Real costs of production and of meeting customer demands are not sufficiently defined. Activity-based accounting analyses are not understood.
The company's strategies fail to take into account the competitive environment and shifts in distribution channels, or are dependent upon excessive customer concentration, aging product lines, or unproven technology.
Benchmarking is more often used by investors to gauge performance compared to industry leaders than as a tool to identify problems. But this technique can help management and lenders to develop an early warning system and keep the enterprise on a sound footing.