Financial ratios to identify companies in financial difficulty

After every bankruptcy, a company’s investors, suppliers, customers and employees invariably ask themselves, “Could we have seen it coming?” Could we have foreseen that the company was in great difficulty? Did we miss any signs of distress?

Often the answer is yes. There are many warning signs that a business is having trouble. Being aware of these signals can help prevent losses. If a business is struggling, chances are you’ll see red flags in its financial statements. At the same time, be alert to changes in its management activities and operations.

Key points to remember

  • There are many warning signs when a business is in trouble, and most can be found in its financial statements.
  • Prolonged periods of negative cash flow (cash outflows exceed cash inflows) can indicate that a business is in financial difficulty.
  • The debt-to-equity ratio compares a company’s debt to equity and is a good measure for assessing a company’s risk of default.
  • Financial statement audits often reveal warning signs.
  • Business and managerial changes, such as a departure from a traditional business model or the sudden departure of key executives, can also signal signs of distress.

Financial statement warning signs

You can tell a lot about a company’s financial health from its financial statements.

The first places to look for signs of trouble are in the cash flow statements. When cash payments exceed cash income, the company’s cash flow is negative. If cash flow remains negative for an extended period, it’s a signal that his cash flow might be low and insufficient to cover bills and other obligations. So keep an eye on the evolution of the company’s cash flow on its balance sheet. Without new capital from equity investors or lenders, a company in this situation can quickly find itself in serious financial difficulty.

Remember that profitable businesses sometimes have negative cash flow and run into trouble. Long delays between when the business spends money to grow its business and when it collects cash receivables can significantly strain cash flow. Working capital can also decline and become negative as accounts payable grow at a faster rate than inventory and accounts receivable. In any case, negative operating cash flow, period after period, should be interpreted as a warning that the company could be heading for difficulties.

Interest payments can put pressure on cash flow, and this pressure is likely to be exacerbated for struggling businesses. Because they face a higher risk of defaulting on their loans, struggling businesses have to pay a higher interest rate to borrow money. As a result, debt tends to reduce returns.

The debt-to-equity ratio is a handy measure for assessing a company’s risk of default. It compares a company’s long-term and short-term debt to equity or book value. Highly leveraged companies have higher D/E ratios than low-leveraged companies.

Audit the warning signs

Don’t forget to take a look at the independent auditor’s report, which is usually published at the beginning of a company’s quarterly and annual reports. If the report mentions discrepancies in the company’s accounting practices, such as how it recognizes revenue or costs, or questions the company’s ability to continue “as a going concern” , take this as a red flag.

Furthermore, notification of a change of auditor should not be taken lightly. Auditors tend to jump ship at the first sign of corporate distress or impropriety. The replacement of the auditor can also mean a deterioration of the relationship between the auditor and the client company or perhaps more fundamental difficulties, such as a strong disagreement on the reliability of the company’s accounting or the reluctance of the auditor to report a “good health check”. Recent academic studies reveal that there are more auditor resignations when litigation risk increases and a company’s financial health deteriorates, so watch out for them.

The fall of US energy and commodities company Enron and its audit firm Arthur Andersen led to the creation of the Sarbanes-Oxley Public Company Accounting Oversight Board (PCAOB), which governs accounting firms acting as auditors of public companies.

Business and management warning signs

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

Be on the lookout for changes in the market environment. Often, they can trigger, or even cause, a deterioration in a company’s financial health. A downturn in the economy, the appearance of a powerful competitor, an unexpected change in buyer habits, among others, can put significant pressure on a company’s revenue and profitability.

Unless these issues are handled effectively, they can be the start of a downfall in the company’s fortunes. Be aware of the company’s customers, competitors, market and suppliers and try to stay abreast of any changing market trends.

Beware of dramatic changes in strategy. When a company moves away from its traditional business model, it can struggle financially. Consider a century-old company positioned as the global leader of a certain widget shifting its central focus to produce a different, unrelated product. This change could indicate a problem within the company.

When a company suddenly starts cutting prices, you have to wonder why. This can mean that the company is in a rush to increase sales volume and inject more cash into the business, regardless of the potentially detrimental impact of the long-term impact of such a decision on the profits or its brand. A desperate grab for cash – also seen when companies suddenly start selling off basic business assets – could be a sign that suppliers or lenders are knocking on the door.

Another sign of distress is the deterioration of the quality of products and services. Naturally, a company that avoids bankruptcy will have an incentive to cut costs, and one of the first things to do is quality. Look for the sudden onset of poor quality work, slower delivery times, and failure to return calls.

Let’s not forget that the sudden departure of key executives or administrators can also signal bad news. While these resignations may be completely innocent, they demand closer inspection. Alarm bells should ring the loudest when the person concerned has a reputation as a successful manager or a strong, independent administrator.

The essential

Generally, when a business is in trouble, the warning signs are there. Your best line of defense as an investor, supplier, customer or employee is to be informed. Ask questions, do your research, and watch for unusual activity.

Sarah J. Greer