By Frank G. De Luca MBA, CMC Owner, Managing Director
Owner, Managing Director, Cambridge Financial Services, LLC
Most professionals dealing in the corporate renewal or turnaround environment recognize that there are certain key items to watch out for, as these are often the harbingers of disasters for the future.
Some of these are obvious and really don’t need explanation, while others are not as obvious. As professionals, we should know what these signs are when they arise in our consulting assignments. We can make the assumption that these are obvious, and often assume that the layman should understand their importance and what the ramifications are for the future.
All professionals and experts in the turnaround business stress early detection. The faster a problem is identified, generally the better chance for a successful turnaround. You want to act while precious assets remain viable to bring about change.
Some of these signals have different meanings for different constituents. For example, an unsecured creditor may see a situation where < there are unencumbered assets as an opportunity to improve its position at the expense of other creditors. On the other hand, a secured creditor with deteriorating collateral may be concerned that the collateral does not further deteriorate and /or lose ground to other creditors.
One important factor to remember in early detection is what I refer to as the “Iceberg Theory”. The boat captain will see the iceberg in an attempt to steer clear of it. But even after seemingly clearing the iceberg, it is the unseen ice under the surface of the water that will sink the ship. The same is true for a business. The problem recognized on the surface is usually caused by an unseen problem not immediately recognizable. Consultants must be alert to these undetectable problems.
As bankers tightened up on credit policy in 2008, companies came under greater scrutiny from lenders for both new loans and for continuation of existing loans. Lenders will note problems on these continuing loans and may take actions not immediately known to you that could impact a client’s ability to survive. As a business consultant to a company, you may run the risk of being insulated from the lender and might not be privy to their impending actions. The more you are able to recognize these danger signs the easier it will be to begin a corrective process.
Problem signs usually noted in two specific areas-Financial and Operational
Financial Signs of Impending Trouble
Cash Flow
Most obvious is cash shortage, cash overdrafts or bounced checks and holding customer checks. This is usually a sign that the cash inflow into the business has somehow become less than actual operating needs for the normal function of the operation. When a company postpones a payment, the initial effect of that postponement is not initially felt since there is no immediate direct repercussion of that event. It is only after many ongoing continuations of that event that the effect is realized, either by vender refusal to ship, increased pricing of new orders or in the end, cancellation of the vendor contract. All events within a business will in turn affect everything else within that business, maybe not immediately, but in the long run.
No Income or Cash Flow Budgets
Ongoing budgets are imperative for an effective management of cash and profitability of operations. Lack of budgeting is a sign of a lack of management control of its business. Without budgeting, the business is operating rudderless and unable to foresee, avert or react to problem issues. Management is not able to make informative and objective decisions.
Fully Drawn Lines of Credit
Lines of credit are typically available from their lenders, which allows the borrower available cash to be employed to operate the business on an ongoing basis. This credit is based upon how the company is projected to use the credit to increase the operation of the business and make sufficient profit for repayment. The lender granted the line based upon the collateral and historical financial strength of the business. In other words, the stronger the financial position of the business, the higher the lender is willing to advance credit. When a company has drawn down its credit line, there is no more availability of additional operating cash and the likelihood of problems is imminent.
Failure to Produce Monthly Financial Statements
Effective mid-size and larger companies have CFO’s or Controllers. Smaller companies have bookkeepers. In either instance, their function is to manage the financial operation of the company. At the end of each month, a financial report of the past month should normally be prepared and reviewed with management by the middle of the next month. This allows the management of the company to review the results of the past month, analyze sales and profit, identify both positive results of that month and plan or adjust future actions. A company that is behind in its monthly reporting has no way to gauge whether it is performing profitable or react to changing events. If the attitude of management is to increase sales, your antennas should be up. Accountants play a viable role in a company’s operation. That is, if they are consulted. If the CPA comes in once or twice a year, the reports are simply a review of past actions. That may be too late to address problems that may be months old.
Others signs of impending financial problems stem around:
- Covenant Violations
- Change of Bank
- Change of CPA or Accountant
- Declining or Non-Existent Capital Investment
- Write off of Accounts Receivables or Inventory
- Litigation
Operational Signs of Impending Trouble
Communication
Communication with management and within each department of the operating company is a necessity. A sure sign of impending trouble can be expected when departments are not communicating with each other or each department believes that that department is the lifeblood of the organization.
Withholding Taxes
Business owners often believe they can make up withholding taxes later when they collect their receivables, when cash flow increases. Unpaid payroll taxes have very onerous penalties. The IRS is not a lender, and unpaid taxes cannot be considered an interest free loan. Furthermore, the IRS considers it stealing, since this money belongs to the employees. Telltale signs of non-payment of taxes may be due to:
- Loss of vendor credit of COD purchase requirements
- A/R collection getting slower
- Costs rising faster than revenues
- Operating losses
Declining Product Quality & Service
Customers and employees are often the first to notice problems, especially if a business owner or manager is cutting corners to improve profitability or is cutting expenses resulting in poor quality. Service isn’t in the sales chain and often considered an unnecessary expense and one of first areas the business owner will look to cut costs. Customers only remember the bad products, not the years of good service. A company may never be able to revive from that stigma. Customer complains accelerate.
Employee Unrest
Employees at all levels are quick to sense trouble. High turnover is a true sign of unrest. Often the best employees are first to leave because prospects elsewhere are greater. This is a major warning sign. Employee turnover indicates that workers are unhappy. Restructure professionals should speak to employees in all levels of the operation. Often, a lower level employee may be the person to shed the most light on what caused the unrest.
Inventory
Whether it is excess inventory, obsolete inventory or a shortage of inventory, each has its own share of effects on a company. Business owners don’t always reason that there is a cost to carrying inventory on the shelves. Such excesses may indicate a change in market patterns not recognized by management, and also may indicate an inability of cash or credit line to purchase new saleable inventory.
Other signs of operational problems stem from:
- Risky accounts
- Non growth or higher growth than the industry
- Market/Industry changes
- Changes in suppliers or order patterns
- Customer concentration
Management Denial
This is one of the hardest to detect since the owner or person in control is most often the one in denial. Entrepreneurs are optimistic so they are always looking on the bright side. This is where the CPA, you or the Turnaround Consultant should be introduced.
Telltale signs:
- Management ego
- Absentee management
- Must increase sales
- Gone with the Wind Syndrome
- “Tomorrow will be a better day”
Authored by:
Frank G. De Luca MBA, CMC
Owner, Managing Director
Cambridge Financial Services, LLC
Raritan Plaza III
101 Fieldcrest Ave., Suite 3E
Edison, NJ 08837
www.cambridgefinancialcorp.com