Time Bombs in Your Portfolio? Know the Early Warning Signs
The California economy is on a multi – year roll and bank loan portfolios are the cleanest in 10 years. So why talk about problem loans? We feel that the current trend of higher leverage combined with rising interest rates could cause economic fallout in 2019 and 2020. This is an opportune time to review the early signs of portfolio trouble.
In our turnaround business we work with many insolvent companies. Although still operating, they have run out of cash and can no longer meet payroll and vendor debts, and have fallen behind on principal and interest obligations to the bank. Typically these companies delay asking for help until all other options are exhausted. By the time we get introduced, it takes quick action and drastic measures to save them.
So how can you as an outsider tell if a company is sliding down the path to insolvency? What are the early warning signs? We reviewed our files containing dozens of troubled companies from the last thirty years to identify some obvious characteristics that contribute to failure. Not all companies that have these attributes will fail, but we do see recurring themes.
Described below are some signals that may help you with the early identification of potential problems.
Common Characteristics of Insolvent Companies
An issue common to all of our clients is the lack of an independent board of directors. We never see insolvent companies with strong outside boards. They may exist, but they are rare in the world of insolvency. The most important thing banks could do to avoid credit losses is to require an independent outside board of directors strong enough to challenge management. Senior management can get very isolated when things aren’t going well, and having trusted advisors can open up communication and options.
A second common issue is weak financial controls. Some may feel that if the CEO is financially savvy, then the company can get by with ‘just a controller’ in the finance function. If you consider the role of the finance function is to simply produce monthly financial statements, you may feel this arrangement is acceptable. However, on a day-to-day basis, who inside the company is telling the CEO that she is making mistakes? Who is monitoring the daily cash requirements of the business and independently reviewing the direction the business is headed? An independent-minded CFO can help identify problems and suggest solutions. Proper reporting can give management the tools it needs to make sound business decisions.
We continue to be surprised at how many people end up running companies ‘by accident’. The accidents may be from natural causes such as the death of a founder, but also include the unexplained departure of a partner ‘for personal reasons’, the buyout of a founder, son or daughter taking over the business, or the hiring of an outside manager without any controls in place to ensure his performance is on track.
All of these warning signs need further attention. Who is managing the manager? Have performance goals been set? What are the repercussions if the manager doesn’t meet goals?
Businesses with family members in key roles provide us with many turnaround opportunities. When tough decisions need to be made, and the owner has to decide between family interests and business interests, which way will he go?
Everyone would be better off financially and psychologically if parents did not insist children enter the family business. The business would benefit from better quality outside management and an open internal playing field so that all the managers are promoted based on merit. Better information about the business gets to the CEO, without ‘family filters’. The business attains a higher value, leaving heirs with more cash. Junior gets to pursue his own career in a field of his choosing.
Other management warning signs include:
- Surprise or frequent changes in key management
- Acquisitions – almost never live up to expectations. The hope that ‘we can get twice the revenues at half the cost’ can turn into ‘half the revenues at twice the cost’. How will key managers and customers be retained at the target company?
- Building a plant or making an acquisition out of state. This can be a huge management distraction. Who will run it? Is the demand justified? Will the company pull the plug if it doesn’t work out?
- Launching some new, unrelated venture in another industry
- Purchase of a jet or a yacht (we have sold three jets in 15 years)
- Change in CEO spending habits – new vacation home, flashy new car – make it difficult to reduce salaries in a downturn.
- Lawsuits of any kind. We think lawsuits represent a failure to communicate.
2. Sales Strategy
We often see successful companies suddenly depart from their base business. This may be due to boredom, hubris, or fear that the base business is being threatened. The company feels that since it is successful in one business, why not another? This may be due to an emphasis on growth over profitability.
While businesses should always consider expansion possibilities, a major departure requires doing your homework and testing the waters prior to jumping in. Are the customers the same? What do they expect? Are the channels of distribution the same? What is the competition? Will you alienate existing customers? Do you know what the company’s core business is? As a lender you need to confirm that the base business is still getting adequate management attention.
We saw a consulting company try book publishing, a circuit board maker enter the military armored car business, and many others. Although in each case there were reasons for the expansion, what was missing was a risk assessment, a trial product, a budget, or adequate market intelligence in the new space.
Other problem areas:
- Introducing too many new and untested products all at once
- Change in sales channel – eliminating sales force, eliminating traditional reps.
- Confusing customers with change in markets without adequate explanation.
- Large concentration of sales with one customer puts company at pricing risk and makes loss of the customer life-threatening. (The paradox of getting the big new order from Costco or Wal-Mart)
- Launching a big new development project without a ‘customer sponsor’. One of our CEOs actually said “We can’t ask our customers what they want – they have no idea!”
Many ‘financial’ problems actually indicate an ‘operations’ problem. Look at inventory, for example. By providing inventory financing, lenders bear a greater burden to understand inventory risk. What are normal inventory turns for this industry? What reaction do you get when you ask your customer to provide an aging of its inventory? Most accounting packages don’t do this, so it normally requires some effort and creativity. It can be a big job and the borrower may be afraid of the information that is discovered. Especially when there is inventory financing. The discovery of stale inventory would likely result in a curtailment of available financing, losses on the P&L, and a hit to net worth. How can a leveraged company sustain this?
Also look for:
- Unusual customer rework and returns. What is really happening here? Do you have people at the company you can talk to besides the CEO? Perhaps this signals overall quality problems. Who is responsible for Quality Control? Are they independent of operations?
- Loss of a major customer (justified after-the-fact because ‘we didn’t make money on that customer anyway’). Normally in a local or regional company, the CEO has a direct relationship with her top 3-4 customers. Loss of a major customer should never be a surprise. Has the CEO lost contact with customers? Are quality problems not being addressed? How are competitors able to cut prices and steal the business if your company cannot?
- Company got stuck with unwanted inventory because … bad sales forecast? Dispute over specs? Is the bank now financing inventory that has been rejected by a customer for quality issues? Are there outdated customer specifications or revisions?
- Is the company building product ‘on-the-come’- in anticipation of orders?
If a company is tight on cash, constantly at the top of its borrowing availability, is begging its vendors to ship product, and yet it has 6 months of inventory on the books, there is a severe marketability problem with this inventory. In addition, if the suspect inventory is greater than the company’s net worth, the company is probably insolvent. Management needs to dump the surplus inventory immediately, even below cost, to generate cash for the business. We see serious mind-sets against this remedy, and have even heard management say it cannot reduce prices of obsolete products because the customers will expect lower prices in the future. There is no satisfactory excuse for waiting.
Also, if the financial story doesn’t add up, something is wrong. One of our clients had flat revenues, but showed profits. However, it continued to borrow more money from the bank. Inventory was growing ‘in anticipation of new businesses. Then there were some inventory ‘adjustments’. The delivery of financial statements slowed down. Then the company replaced the controller. Ultimately it ran out of cash and required a major outside intervention. The lesson? Don’t rely on profits alone as a sign of health – they can be manipulated many ways.
Other financial warning signs:
- Change in CFO / controller. How much did they know about management problems?
- Change in outside accountants. Did the accountants want higher reserves on assets?
- Spouse keeping the books – no independence Unusually slow financial statement delivery, or evading your phone calls.
- Frequent surprises Restated financials (back-dating problems). “We uncovered some one-time inventory problems that really relate to last year.” Oh, really? How many years of profits were just wiped out?
- Overall declining financial trends
- Financial statements show profits, but company needs to borrow more and more money.
- General sales decline
- Shipping higher volumes at lower prices
- Decline in operating cash flow
- Swelling inventory with no increase in sales – longer turnover days
- Company unwilling to sell obsolete inventory to recover cash
- Stretched vendors – either growing A/P days or more delinquencies
- Change in selling terms or in customer payment patterns
- The greater the company’s leverage, the more sensitive it is to any financial setback.
- Companies with ‘cash-flow’ term loans will often turn the fastest
Lessons We Have Learned
- It’s not easy to kill a company – it takes persistence and unwavering determination.
- Chances are, if the person in charge is determined to run a company into the ground, he will succeed.
- Incompetence is not illegal; there is no lawful method to stop an owner from tanking his company.
- Often everyone in the company knows what is wrong except the person in charge.
- If you continue to do the same things the same way you will get the same results.
- Putting family members in the business is bad for the business and bad for the family member.
- Bad management occurs in good economic times and bad, but in general most problems surface in the years after a downturn.
- Insolvency – there is a cure.
Things that don’t work when insolvent: (all of these really happened)
- Sue everyone trying to help you, including the bankruptcy judge and your own attorneys
- Draw a gun on federal marshals
- Put additional personal funds into the company (never do this unless there is a plan in place to fix the business.)
- Hope things will ‘get better’ on their own.
- Move out of state to avoid your bank guaranty
Things that do work:
- Ask for help.
- Acknowledge mistakes and ask creditors for time to come up with a plan.
- Tell the truth about the situation and what happened.
Company Summary Triggers
Spouse came in to micro-manage the business
New business venture – entered board game business
Unable to sell obsolete inventory
Widow took over business, told its largest customer to go away, and put incompetent son in charge
New business venture – entered polishing business
Built new plant in different state
Partner left to start complimentary business
New business venture – book publishing
Out of control personal spending habits by owner
Founders turned business over to outside manager
New product launch – no customer champion
Weak controller, no CFO
Recurring inventory adjustments
Extensive customer rework
Launched major new plant out of state
Unable to pull the plug when it didn’t work out
Seventeen acquisitions in 4 years
No common accounting system
Management from outside the industry
President fired the sales staff with no replacement concept
Out of state ownership
Resisted offshore sourcing
Specialty Auto Parts
Lost business line representing 40% of sales
Prolonged failure to cut back
Overly dependent on one industry in one geographic region
Founders turned business over to outside manager who had previously served jail time for embezzlement (no, we don’t make this stuff up)
Too many family members in the business
Lack of accountability
Founder died, left business to untrained insider
Conflict over family members in the business
About Burke Capital Corporation
Burke Capital Corporation is one of the region’s most highly respected catalysts to business prosperity. For over 20 years, Burke Capital Corporation has provided capital, expertise and management to enable significant client performance gains, often in very challenging times. For more information, go to burkecapital.net or call us at (650) 579-5699. The company’s corporate headquarters is located in Burlingame, California.
1021 Burlingame Avenue
Burlingame, CA 94010 |135