Big Company Red Flags You Can't Afford to Miss
Warning Signs a Public & Other Large Company May Be in Trouble
Monitoring and evaluating the credit risk posed by public companies and other large firms differs significantly in comparison to small and mid-sized businesses. While the principals of credit are the same for businesses of every size, there is a lot more information on the big guys making it easier to see any red flags that suggest they are in trouble.
In a sense, that’s fortunate because it’s much more likely a large firm, rather than a small business, is your biggest customer. Because most of your biggest customers will be larger firms instead of smaller, it is typically the larger firms that will require higher credit limits. Consequently, a large percentage of your accounts receivable (AR) is likely to derive from large firms. Because there is more information on large firms, especially when they are publicly traded companies or have issued bonds in the public marketplace, there are more substantial opportunities to sight a red flag that might indicate they are in financial distress.
Beware—Commercial Bankruptcies Are Accelerating
In our current economic climate, watching out for customer red flags is essential. That’s because commercial bankruptcies have been rising and are expected to continue rising. Here a sample of the news on this front:
Commercial bankruptcy filings across all chapters increased 20% in the first 9 months of 2024 compared to 2023, with 22,550 filings versus 18,774 according to Epiq AACER. Meanwhile, commercial Chapter 11 filings increased 36%
Allianze Trade forecasts bankruptcies in the US to increase by 12% in 2025.
According to BankruptcyWatch, the U.S. Department of Justice's U.S. Trustee Program estimates that bankruptcy filings will double over the next three years.
If you are not on the lookout for customer red flags, especially those raised by public firms and other large enterprises, you will be at increased risk for incurring bad debt losses. Sighting red flags early on allows you to mitigate these risks and reduce your potential losses.
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Watch Out for These 14 Red Flags
The task of figuring out who in your portfolio is at risk will take some hard work and require your time and attention, but it has to be done. Most firms derive 80 percent of more of their revenue from just 20 percent of their customers. Those are the accounts you need to monitor very closely.
To help you, we’ve identified 14 red flags you need to put on your radar. Also, be forewarned that we’ve had to get a little more technical than usual with some of the financial analysis concepts, but that’s simply the nature of the beast. Here they are:
Declining Sales Base: When top line revenue is going South, everything else becomes much more difficult. Watch out for companies that begin shedding assets to make up for the decline in sales. Also, watch out for firms that have a declining customer-base.
Store, Branch, Warehouse or Factory Closings: Closing facilities reduces overhead, but often at the cost of lessening sales and a shrinking clientele. Often this occurs because a competitor is increasing market share (think Wal-Mart and Amazon).
Consistent Net Losses: Businesses can survive periods of negative earnings, but consistent losses are difficult to overcome
EBITDA Issues: Declining EBITDA (earnings before interest, taxes, dividends, and amortization) signals weakening. In addition, if the ratio of debt to EBITDA is rising relative to a firm’s peers, it will be at a competitive disadvantage.
Declining Interest Coverage Ratio: This is calculated by dividing a firm's earnings before interest and taxes by its interest expense over a period of time, typically the prior year. You want to see a ratio of greater than 3 to 1. At this level there's a cushion, but as you get closer to 1 to 1, the business just isn't generating enough cash.
Bond Market Fluctuations: Bond market trading is mostly done by professionals as compared to the stock exchanges, which often change for irrational, or non-company specific reasons. When there is significant price movement in a customer’s bond offering without public information being released you should investigate further. Furthermore, when a bond is downgraded from investment to non-investment (junk) grade (thus becoming a fallen angel), the company's borrowing costs rise, which can create a downward spiral if the firm doesn't act to shore up their finances and operations.
SEC Investigations: When you see a customer fall under an SEC, or any other critical investigation, you need to monitor it closely.
Management Turnover: Whenever there is a change in management, you need to take notice. Sometimes the change can be positive, especially if the departing executives were leading the company in the wrong direction, but an ongoing high rate of turnover is a harbinger of underlying problems.
Management Discussing Cash Flow: When a firm says (typically on a conference call discussing financial results) that they are “managing their cash flow,” Wall Street will typically be pleased, but trade creditors need to expect the worst. The easiest ways to hang onto your cash longer is reduce inventory and/or slow payments to your suppliers. This will show up on their balance sheet when Days Payable Outstanding (DPO) starts rising, and can be a sign of liquidity problems.
Slow Moving Inventory: The faster inventory turns over, the better. Slow moving inventory helps make the current ratio look good, but it is bad news from an operational standpoint. Rising inventory levels are often followed by heavy markdowns that impact margins.
Involvement of Non-Bank Lenders: When an asset-based lender gets involved, it is likely because the company was not able to secure traditional bank financing. Asset-based lenders charge higher interest rates to offset the lower credit quality, and are more concerned with the quality of collateral than a banker.
Limited Availability and Covenant Amendments on Revolving Loans: Loan covenants cover a myriad of issues, including filing financial statements, asset sales, but the most relevant for credit analysis are the financial covenants. When credit availability becomes limited, the bank may waive one of the loan covenants or amend the covenant to avoid having to call in the loan. When this happens, the borrower is required to report in their quarterly financial statement to the SEC that there has been a covenant amendment. You should take that as an early warning sign. In any event, it is important you determine how much additional credit is available under a customer’s revolving loan, which often is much less than it appears.
Additional Rounds of Debt Financing: An increase in your customer’s debt leverage is never a good sign. Also, when a bank will not amend a loan covenant, and instead calls the loan, companies often turn to non-bank lenders, which will increase their borrowing costs as will secondary debt financing.
Default on an Existing Loan: The other outcome, when a bank calls a loan due to covenant violations, and the firm is not able to access capital elsewhere, is a default by the borrower. If this event does not put the borrower in bankruptcy, chances are it is not far away.
Putting Theory into Practice
With the serious economic headwinds we are facing, it is more important than ever to closely monitor your customers’ financial status. For the past few years, corporate America has been leveraging debt at a record pace, and with interest rates expected to remain high, servicing that debt remains a financial burdern.
Elevated borrowing costs will sink some large corporations, especially across the retail sector. In addition, the construction industry and some manufacturing sectors are expected to see an uptick in insolvency filings along with retailers as consumer demand declines, particularly for discretionary spending and luxury products.
Many of the red flags discussed will show up in your customers financial reports filed with the SEC. Others may be revealed on a sales call, from reading the papers, or tracking your customers on the Internet. These are all things that need to be done with regard to monitoring your critical customers.