Red Flags Revealed by Your Customers' Financial Statements
Six Financial Indicators A Business Is Headed the Wrong Way
Commercial bankruptcies have been surging since mid-2022. Chapter 11 filings, used by businesses hoping to reorganize, have increased by 34 percent in the first six months of 2024 compared to last year. Chapter 7 commercial liquidation filings are up 28 percent and sub-chapter V small business elections are up a staggering 61 percent despite the filing threshold recently being cut in half. Struggling businesses, especially in retail, are driving this spike according to statistics tracked by BankruptcyWatch. High-interest rates are the underlying culprit, squeezing many of these firm’s options. And the future is bleak — the U.S. Department of Justice expects a sharp increase in bankruptcies with the U.S. Trustee Program predicting filings will double over the next three years.
With bankruptcy filings skyrocketing and this trend expected to continue, trade creditors should prepare for delinquencies to rise within their accounts receivable (AR) portfolios. In addition to a comprehensive and pro-active collection regimen, the first line of defense for credit grantors involves regular monitoring of their AR portfolio for customers exhibiting red flag behaviors. Your Virtual Credit Manager has already covered this topic from several different perspective. You may want to check out these previous posts in addition to learning about the financial distress markers this article will cover:
The climbing number of bankruptcy filings underscores the precarious financial environment many businesses face today, particularly in sectors that are being significantly impacted by inflation and other economic challenges. Understanding the early warning signs of financial distress is therefore essential for mitigating AR portfolio risk.
Insights From Analyzing 10 Established Retailers
Last December, international credit bureau, CreditSafe, published their analysis of 10 US-based retailers that were established over 75 years ago, had annual revenue of at least $500 million, and, if there was a past bankruptcy, it had been filed from 2020 to 2023. As it turned out, half of this group had indeed filed for bankruptcy during this period. Editor’s note: CreditSafe periodically publishes similar studies on other industry sectors, most recently transportation and manufacturing.
This particular CreditSafe trends report, Financial and Bankruptcy Outlook: Retail, provides key insights into the financial condition of these 10 retailers as well as observations about the group as a whole. According to the report, the problems that force retailers down the road to bankruptcy exist despite financial planning, forecasting and analysis, cash flow management and inventory planning. It then concludes:
More often than not, other factors can play a major role. For instance, the retail industry was hit especially hard by the pandemic, which shut down physical stores for months at a time. At the same time, rising inflation, a cost-of- living crisis, increasing theft, growing credit card delinquencies and supply chain disruptions have all played a part in the demise of some retailers over the last three years.
It is imperative, however, that one recognize that these types of factors are all contributors to the working capital and cash flow challenges that ultimately force a company into bankruptcy. This being the case, warning signs can be uncovered through financial statement analysis, especially when you are able to make period-to-period comparisons.
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Six Financial Indicators a Company is Headed Down the Tubes
Accounting and financial analysis is the grammar used to track and define business performance. Financial statements provide the storyline. By studying what is happening, as revealed by your customers’ periodic financial statements, you will accumulate insights you can use in your credit analysis. It’s hard for financial challenges to hide in financial statements, so if you pay attention, you will be forewarned of emerging challenges and have time to plan a response to protect your company’s AR. Here are six indicators of financial distress:
1. Imminent Cash Depletion
It is often safe to sell, at least for a while, to unprofitable companies that have cash to spare. Inevitably, chronically unprofitable ventures will run out of cash. When a company’s cash flow reservoir dips below six months, you need to be very careful. When there is only three months cash flow in the pipeline, your customer is at a critical juncture. Urgent action is then needed to either secure more funding, increase cash flow, or cut expenses. These things takes time to gain traction and three months is barely enough time to evaluate if these maneuvers will be successful. Furthermore, creditors should keep in mind that any additional monies they collect above the normal course of business in the 90 days before a bankruptcy filing may be claimed as preference payments, which the creditor may be forced to forfeit to the bankruptcy estate.
Assuming there are no changes in operations or financing and using a company’s statement of cash flows, it isn’t difficult to determine the length of time before your customer will run out of cash. If the customer is burning through $25,000 of cash per month and cash on hand is $150,000, their tank will be running on empty in six months and it is high time to begin taking steps to recover all outstanding receivables.
2. Sinking Quick Ratio
Quick ratios provide a measure of a company’s liquidity. It’s a simple calculation — current assets divided by current liabilities — that is taken right off the balance sheet. A quick ratio of 1:1 or higher suggests a company has sufficient liquid assets to cover short-term liabilities. When the ratio drops below 1:1, your customer will find it difficult to meet all it’s short-term obligations, such as payroll, as well as supplier and loan payments.
You should watch out for growing liquidity issues when a customer’s quick ratio is declining. Sluggish sales tend to reduce current assents just as poor AR collections will tend to cause an increase in accounts payable (AP). Both these situations can cause a firm’s quick ratio to sink. Furthermore, the lower the quick ratio, the harder it is to respond to unexpected challenges or pursue new opportunities. Inevitably, persistent negative cash flow and difficulty meeting short-term obligations are red flags you don’t want to ignore.
3. Inventory Build-ups
When a customer’s inventory levels are rising or inventory is turning over slowly, there may be several culprits at work such as weak sales, obsolete products or supply chain issues. When inventory levels are increasing, but sales are not, your customer may be purchasing product and manufacturing new inventory at a greater rate than demand, suffering from sub-par cost accounting, or again dealing with issues related to product obsolescence. As a consequence of any of these issues, your customer will end up overstating profit on their income statement, thereby masking the full extent of their enterprise’s financial difficulties. In addition, inventory issues may also be directly observed besides being uncovered in a customer’s financial statements. Enlist your sales team to be on the lookout for customer inventory anomalies.
4. Thin Gross Margins
Most companies operating with gross margins regularly under 20 percent from period-to-period are going to run into financial difficulties. If profit margins are declining while revenue is stable or rising, your customer’s operations may either be inefficient or they are being battered by pricing pressures. Acceptable gross margins can vary widely by industry, so there will be exceptions to this rule, but few firms operate as efficiently as Costco with thin margins. Also, when reviewing a customer’s gross margins, make sure labor, shipping, import fees, returns and allowances, and other overhead costs have been included in the cost of goods sold.
5. Declining Revenues
A shrinking sales funnel may be an early warning sign of a downturn in demand for your customer’s products. Declining revenue over multiple quarters or years will cause most companies serious problems unless they can cut costs and otherwise restructure their business model. Sales are the ultimate source for cash flow, so when sales decline, there is financial pressure all the way down the line, and therefore are a warning sign that financial difficulties may be just around the corner.
6. Rising Returns and Allowances
The issue of returns and allowances was already mentioned as an issue that can cause gross margins to be overstated. In addition, excessive returns will often increase obsolescent inventory. An uptick in refunds or returns can also be a clear sign of customer dissatisfaction, either with product quality or the customer service experience. Besides the impact on cash flow, there is also a reputational risk with high returns that can snowball and ultimately affect sales. Lastly, rising returns and allowances is another situation where your sales team can provide an early warning.
Food for Thought . . .
In light of surging bankruptcy filings and the challenging economic environment, it is more important than ever for creditors to be vigilant in monitoring the financial health of their customers. The indicators outlined above serve as critical warning signs that can help identify financial distress before it spirals into insolvency. Keeping a watch for these financial distress indicators, is a first step for those tasked with mitigating customer credit risk and protecting their company’s AR portfolio.
Ultimately, a primary key to navigating this uncertain economic landscape lies in creditors having a thorough understanding of financial statements and the ability to recognize early signs of trouble. The sooner thesee risky situations are identified, the more time there is to implement strategies to address them, whether that means tightening credit terms, ramping up collections, or seeking alternative risk mitigation solutions.