Signs of Financial Distress

What Is Financial Distress?

Financial distress is a situation where a company struggles to meet its financial obligations. This may be related to paying off debt, insufficient cash flows or liquidity issues. The underlying drivers behind these issues maybe be due to operational underperformance, liquidity problems, worsening credit metrics or something outside the company.

Understanding Financial Distress

Understanding financial distress involves recognizing the early warning signs of impending issues. These signs can be classified into financial and non-financial categories. Financial signs of distress include issues with liquidity and leverage, which determine how long the company can continue operating and the sustainability of its capital structure. Non-financial signs can include operational underperformance, such as long-term declines in sales and profitability, loss of key customers or contracts, and significant costs or CapEx overruns or delays.

Signs of Financial Distress

Signs of financial distress include operational underperformance (long-term declines in sales and profitability, loss of key customers or contracts, significant costs or CapEx overruns or delays), liquidity problems, and worsening credit metrics. These signs indicate that the company may be struggling to meet its financial obligations and may need to consider restructuring or other measures to improve its financial situation.

Operational Underperformance

Material, operational or financial under performance can be indicated by three things:

Long-term Declines in Sales and Profitability

While occasional declines in sales and profitability are normal, if this happens consistently over many periods, including frequent profit warnings for public companies, then questions can be raised about how well the company is being run, whether it can compete against its peers, or even ultimately, if it still deserves to remain operating as a going concern.

Loss of Key Customers or Contracts

Losing key customers or contracts means a lower levels of sales, which in turn reduces the company’s cash generation, which is detrimental in a distress situation.

Significant costs or CapEx, Overruns or Delays

Experiencing expenses above expectations can generate unplanned cash outflows and put pressure on a company’s operations as it reduces available liquidity.

Liquidity Problems

There are a number of signs a company might be struggling with liquidity problems including a consistent, limited or negative free cashflow generation over multiple years.

Unable to Generate Free Cashflow

A company that can’t generate free cashflow and is in constant need of additional financing to keep operating is commonly known as a zombie company, and it requires special attention. Since this is not sustainable in the mid to long run.

Maxed out Overdraft

Constant use of overdraft or being fully drawn on revolving facilities. If revolving credit facilities are constantly maxed out, it means that the company needs much more liquidity than usual. Such facilities are mostly used for working capital purposes, and therefore not having access to additional funds might interfere with the normal day-to-day operations of the company, such as not having enough financing to fund inventory purchases ahead of a busy seasonal period or such as the lead up to the festive period for many retailers.

Limited Availability to Raise Additional Financing

Limited availability to raise additional financing when a company can’t raise additional debt. If liquidity ever becomes tight, the company will be in deep trouble. Since arranging alternative types of financing, for example, through disposing of assets or raising equity is more complex and time consuming than using pre-arranged lines of financing. A company in distress that is running out of cash sometimes doesn’t have much time to play with.

Delays in Paying Salaries, Taxes and Invoices

Constant delays in paying salaries, taxes, or supplier invoices are a clear sign of liquidity issues. Companies delaying critical outgoings such as salaries is a key indicator that they are trying to preserve as much liquidity as possible and therefore could be into distress.

Worsening Credit Metrics

Worsening credit metrics is also a financial sign of distress. Key indicators include:

Significant Levels of Leverage

Leverage is typically tracked using their net debt to EBITDA ratio. If this is way above competitors’ levels or the historical average for the company, then this suggests worsening credit quality. Comfortable leverage levels depend on the industry and the specific company, but broadly speaking, leverage ratios above eight times net debt to EBITDA would indicate a very risky and unsustainable capital structure.

Limited and Declining Interest Coverage Ratio

This is most often tracked using the EBITDA to interest expense ratio. A declining interest coverage ratio indicates that the company is less and less able to afford its interest expense. The usual threshold for concern is when this ratio drops below two times EBITDA to interest expense. However, care must be taken when analyzing these credit metrics as they fluctuate together with EBITDA. If a company’s EBITDA is affected by one-off events such as restructuring costs or impairments, these metrics might look excessively bad. However, if EBITDA is normalized, which involves excluding the impact of these one-offs, the situation might not be as concerning as such. Using a normalized EBITDA for these ratios is very important.

Accounting Issues

Non-financial signs of distress are softer than financial ones but can also be important in identifying potential problems with a company. These signs include considering any accounting issues, analyzing and assessing management or company behavior, and looking out for any significant operational disruption.

Constant restatements or delays in filing financial accounts would be concerning as it might indicate that the company’s finance function doesn’t have control over the company’s financial records, or might have something to hide hiding or understating liabilities. This would be very concerning as the company’s real leverage might be significantly higher than what is currently presented in the financial statements.

Accounting Issues Example

This was one of the key problems at Enron, a large American energy company that went into administration in 2001. It made extensive use of special purpose entities to hide debt financing off the company’s balance sheets, which disguised its true level of indebtedness.

Management or Company Behavior

Companies are run by people, so looking at their actions can provide insights into the company’s performance. Warning signs would include:

High Turnover or Loss of Key Staff

Loss of staff responsible for key divisions or operational activities can be significantly detrimental to the company’s performance due to the loss of knowledge of how the company operates internally. It may also indicate that people are leaving because they know all is not well within the company. This also has the effect of demotivating the remaining employees.

Frequent Changes in Auditors

Another warning sign is frequent changes in auditors. This usually happens when a company has something to hide, or the auditors are not confident about the accuracy of the numbers they are being presented with by the company.

Nervous, Unresponsive, or Evasive Management

If management becomes increasingly uncooperative with analysts, requests for information about the company, or becomes more delayed in responses to analyst questions, this might indicate that management are unavailable as a result of trying to find emergency funding or have something to hide.

Misrepresentation

Misrepresentation or outright lies about the current state and or prospects of the business. Again, this usually happens when management doesn’t want to disclose what is truly happening within the company.

Significant Operational Disruption

Signs that might indicate future financial problems from disruption to the operations of the company include the following:

Technological Obsolescence

The products lose relevance due to technological obsolescence. A great example of this is Kodak and its physical photographic film business, which was a highly profitable market leader for many years before being disrupted by digital photography. Kodak ultimately filed for bankruptcy protection in the US in January 2012.

This has also been the fate suffered by a number of companies due to the advancing digital economy, such as the Blockbuster video chain or the home retailer, Bed Bath and Beyond, entering bankruptcy as a result of a loss of sales from their physical stores.

Loss of Key Operating or Distribution Licenses

Loss of key operating or distribution licenses, means companies lose access to important products or markets leading to significant drops in revenue and cash flows. In some cases, this may even lead to a company ceasing to operate. For example, in the case of a port operator losing its operating license means it would have to halt its business activities and would not be viable as a going concern unless the operating license were to be restated and litigation issues.

Litigations Issues

Some litigation issues can threaten the company’s operating license. For example, a mining company being sued for environmental damage may lead to its operating license being revoked, or may result in liabilities that are too expensive for the company to afford

How to Remedy Financial Distress

Remedying financial distress often involves a restructuring advisor who identifies potential restructuring candidates and assesses the situation in detail ahead of time. Potential solutions usually include a turnaround plan, which outlines measures to improve profitability and conserve cash, asset disposals to raise additional liquidity, or ultimately, the liquidation of company assets if the company is no longer viable as a going concern.

Conclusion

Financial distress is a complex situation that can be identified by various signs, both financial and non-financial. It’s crucial to understand these signs, which range from operational underperformance and liquidity problems to worsening credit metrics. The behavior of management can also provide valuable insights. By recognizing these signs early, companies can take necessary measures to mitigate the situation and potentially avoid severe consequences such as bankruptcy.