Small Business: Warning Signs of Distress

Small Business: Warning Signs of Distress

By: Tommy Onich BBA,CTP

Most companies experiencing difficulty can be saved if their problems are caught soon enough.

As a group these companies almost always share a specific characteristic which is DENIAL. Once denial creeps into a business it becomes ubiquitous with both depth and scope. At some point the level of toxicity is fatal.

Frequently specific warning signs or red flags that if heeded, can give the company time to act before it is too late. There are three basic types of warning signals:

  • Mathematical models forecasting distress.
  • Negative trend signals.
  • Negative behavioural signals.

Mathematical Forecasting are usually multivariate mathematical models that use key financial ratios and information over time. This approach is based upon internal information and financial statements. These are therefore dependent upon the accuracy, reliability and relevance of financial data. Often in an environment in which even a vague notion of performance management principals have disappeared.

In almost three decades as a commercial lender or turnaround manager, almost every case that I have seen has had problems with the accuracy and reliability of data.

Negative Trend signals are not mathematically precise: they are more subjective and cover a variety of functions. They do not have any absolute good or bad and they can vary among industries, or even within a company.

For example, I often consider market-driven signals. The most indicative are declining margins and a declining market share. A strong negative signal is an erosion of margins where increased sales do not translate into profits. Declining margins together with declining market share is a sure indication of trouble. 

Other signals that are not market driven but are financial in nature include:

  • The company has a high breakeven. I define this as being where a company could not meet its debt obligations with even a slight decline in sales.
  • Assets are being leveraged to the maximum margins allowed by secured lenders. This is usually liquidation value.
  • Debt is steadily increasing but not necessarily to finance income producing assets or growth.
  • Pressure on operating lines and the company exceeds the authorized operating line on an unplanned basis. 
  • Any debt used to finance losses.
  • A sale/lease back done to raise capital without a plan.
  • A lack of reinvestment- this is perhaps the earliest sign of decline.

Negative Behavioural Signals cannot be measured but they are still very important. The most important of these is poor communication. The key to good communication in a business is a three way path between division, staff, and operating personnel.

Operating personnel are like sergeants in the army, they are the backbone of the organization. It is essential that operating personnel feel free to communicate. It is far more important to communicate bad information than good. Good communication (especially in the face of trouble) stops when the messenger delivering bad news feels they will be punished, or no one will listen.

Low morale, another important negative behavioural signal takes a little perception and intuition to perceive. In small companies a visit to those in the “front line” is important. Sometimes a visitor can see obvious signs of decline, such as dingy offices or a messy shop floor. When a small company is experiencing low morale these things are evident. In larger companies these may be more difficult to see. The will likely have sufficient resources to make the situation look better than it is.

Most companies facing difficulties can be saved if action is taken soon enough. What is absolutely crucial is speedy, resolute action by the company’s management in light of one or more red flags.

The one common characteristic of all failed companies is denial until the trustee is appointed. In the face of any warning signal, the only management sin is hesitation. 

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