Find the financial ratios of companies in financial distress

After each bankruptcy, the company’s investors, suppliers, customers, and employees would ask themselves: “Can we foresee it? Can we predict that the company is in big trouble? Are there any distress signals we missed?”

Usually, the answer is yes. There are many early warning signs that the company is experiencing problems. Understanding these signals helps prevent losses. If a company is in trouble, you are likely to see red flags in its financial statements. At the same time, pay attention to the changes in its management activities and operations.

Key points

  • Many warning signs will appear when a company is in trouble, most of which can be found in its financial statements.
  • Persistent negative cash flow (cash outflow exceeds cash inflow) may indicate that the company is in financial distress.
  • The debt-to-equity ratio compares the company’s debt with shareholders’ equity and is a good measure of the company’s debt default risk.
  • Financial statement audits often find warning signs.
  • Business and management changes, such as deviations from traditional business models or the sudden departure of key management personnel, can also be signs of distress.

Financial Statement Warning Sign

You can learn a lot about the company’s financial status from the company’s financial statements.

The first place to look for signs of problems is the cash flow statement. When cash payments exceed cash income, the company’s cash flow is negative. If the cash flow remains negative for a period of time, it may indicate that the cash flow may not be sufficient to pay bills and other debts. Therefore, please pay close attention to changes in the cash position on the company’s balance sheet. If there is no new capital from equity investors or lenders, a company in this situation will soon fall into serious financial distress.

Remember, profitable companies sometimes experience negative cash flow and get into trouble. The long delay between the company spending cash to develop its business and the receipt of cash receivables can severely extend cash flow. As accounts payable are growing faster than inventory and accounts receivable, working capital may also fall and become negative. In any case, period after period of negative operating cash flow should be interpreted as a warning that the company may be in trouble.

Interest repayment will put pressure on cash flow, and this pressure may increase for troubled companies. Because of the higher risk of defaulting on loans, troubled companies must pay higher interest rates to borrow money. Therefore, debt tends to reduce returns.

The debt-to-equity ratio is a convenient indicator to measure the company’s debt default risk. It compares the company’s long-term and short-term debt with shareholder equity or book value. The D/E ratio of highly indebted companies is higher than that of low indebted companies.

Audit warning sign

Don’t forget to focus on the third-party audit report, which is usually published in front of the company’s quarterly and annual reports. If the report mentions differences in the company’s accounting practices—for example, how it records revenue or calculates costs, or questions the company’s ability to “continue operations”—think it as a red flag.

More importantly, auditors should not be notified of changes lightly. Auditors tend to switch jobs at the first sign of trouble or misconduct in the company. The replacement of auditors may also mean that the relationship between the auditor and the client company has deteriorated, or it may be a more fundamental difficulty, such as a strong disagreement on the reliability of the company’s accounting, or the auditor’s reluctance to report “good health”. Recent academic research has found that when litigation risks increase and the company’s financial situation deteriorates, more auditors will resign-so beware of them.

The collapse of the American energy and commodities company Enron and its audit firm Arthur Andersen led to the establishment of the Sarbanes-Oxley Public Company Accounting Oversight Board (PCAOB), which is responsible for managing accounting firms that act as auditors of listed companies.

Commercial and management warning signs

Although the information in financial statements can help measure the health of a company, it is important not to ignore signs of distress in management and operations. Many private companies do not disclose financial statements to the public; therefore, business information may be all available information to assess their well-being.

Pay attention to changes in the market environment. Usually, they will cause (if not cause) the deterioration of the company’s financial situation. The economic downturn, the emergence of powerful competitors, unexpected changes in buyer habits, etc., will all put serious pressure on the company’s revenue and profitability.

Unless these issues are effectively managed, they could be the beginning of a decline in the company’s fortunes. Understand the company’s customers, competitors, markets and suppliers, and strive to stay ahead of any ever-changing market trends.

Be vigilant for huge changes in strategy. When a company deviates from its traditional business model, the company may fall into financial distress. Suppose a company with a 100-year history is positioned as a global leader in a small part, shifting its focus to producing different, unrelated products. This shift may indicate a problem within the company.

When a company suddenly starts cutting prices, you should ask why. This may mean that the company is eager to increase sales and get more cash for the business, regardless of the possible adverse effects of such actions on profits or the long-term impact of its brand. Desperately grabbing cash — which can also be seen when a company suddenly starts selling core business assets — may indicate that a supplier or lender is knocking on the door.

Another sign of distress is the decline in the quality of products and services. Naturally, a company that is fending off bankruptcy will have an incentive to cut costs, and one of the first things to do is quality. Look for the sudden appearance of rough workmanship, slower delivery times, and non-return of calls.

Lest we forget, the sudden departure of key executives or board directors may also herald bad news. Although these resignations may be completely innocent, they need to be examined more closely. The alarm bell should ring the loudest when the individual concerned enjoys the reputation of a successful manager or strong independent director.

Bottom line

Usually, when a company is in trouble, the warning signs are there. As an investor, supplier, customer or employee, your best line of defense is to be informed. Ask questions, conduct research, and be alert to unusual activity.


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