Beyond the Numbers: 5 Red Flags That May Indicate Financial Distress

Financial statements help managers, lenders and investors evaluate a company’s financial performance. But they tell only part of the story — and they might not reveal financial distress until it’s too late, especially for companies that issue only annual reports. So it’s critical to watch for these five common warning signs indicating a company may be struggling to make ends meet:

1. Financial reporting delays. Late financial statements may signal unqualified accounting personnel, inadequate recordkeeping or even fraud. In some cases, 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 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 Auctions bridge temporary cash shortages and help purge a company of idle or outdated equipment.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 are usually better equipped to notice these distress signals sooner than outside stakeholders. However, ongoing due diligence can help. For instance, if you have a financial interest in a particular company, consider reviewing news stories for recent developments, following the company and key employees on social media, scheduling quarterly meetings with management, and visiting facilities that are publicly accessible (such as retail stores and job sites). A lender or franchisor who suspects a company’s performance is deteriorating may even request an agreed-upon procedures engagement that targets perceived weaknesses and recommends possible improvements. Contact us for more information.

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