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November 29, 2022

Red Flags That a Company May Be in Financial Trouble, Part 2

Having advance knowledge that a company you do business with (a customer, a supplier, a tenant, a borrower, etc.) is having financial problems can help mitigate the disruption and expense if it fails or files for bankruptcy. This alert is a continuation of the list of red flags to watch for that was presented in Part 1. Like Part 1, this list includes factors applicable to a number of types of business relationships, so not every factor will be applicable to your particular relationship. While the occurrence of one or more of these factors does not necessarily mean a business is or will soon be in trouble, they should at least cause a heightened awareness and, if possible, some additional inquiry and investigation to attempt to determine whether the company with which you are doing business is financially healthy and able to fulfill its obligations.

1. Lack of Activity

If you are visiting a company’s facility or place of business during business hours and there seems to be a lack of or insufficient activity or employees, that can be a sign of problems within the business. 

2. Changes to Senior Management

Senior management changes are a normal part of the lifecycle of every business. However, a turnover of all or a significant portion of senior management, especially if abrupt or unexpected, could represent a reaction to major problems within the company.

3. Death, Disability, or Retirement of the Company Founder

For entrepreneurial companies, losing the company’s founder, who is often its driving force, can lead to problems if an appropriate transition plan is not in place and the founder is not replaced with sufficient managerial, and sometimes technical, talent.

4. Changes to Accountants, Attorneys, and Other Professionals

A change in the company’s accountants, attorneys, or other professionals, especially if these changes occur at the same time, could indicate a resignation by those professionals in response to something happening within the company.

5. Sale of Major Assets

The sale of major or “core” assets, especially if sudden or at distressed prices, often indicates an urgent need for cash or other issues.

6. Major Casualty Loss

A fire, storm, or other major casualty loss, even if the business is fully insured, can cause severe harm, especially if rebuilding and returning to production will take a long time. Business interruption insurance can alleviate, but not totally eliminate, this risk.

7. Radio Silence

While not always the case, when a company you are doing business with stops communicating, returning phone calls, etc., that is often an indication that it is dealing with significant financial problems, operational turmoil, or other problems and either does not have the time to deal with you or does not want to reveal what is going on.

8. Delayed Financial Reporting

In a situation or arrangement in which the company is required to provide financial reporting, failure to provide that reporting can indicate either a lack of sufficient internal financial controls, a desire not to convey bad news, or both.

9. Inaccurate Communication

While an isolated nonmaterial mistake can sometimes be explained and overlooked, repeated or major inaccuracies often indicate a lack of adequate internal financial controls, integrity issues, or both. In any case, your business will be well served by carefully examining its relationship with the subject company.

10. Declining Financial Metrics

If financial reporting is provided, factors such as decline in profits or cash flow; decreased sales; increased dependence on debt; and significant changes in inventory, accounts receivable, or accounts payable may indicate that a company is the early stages of decline even if it is not insolvent, is still showing a profit, and has not breached its obligations.

11. Financial Covenants

If your business arrangement with the subject company contains financial covenants, simply meeting the covenants should not end your inquiry. If the company traditionally meets its covenants with room to spare but now is getting close to exceeding them or its performance is worse than it has been previously, even if still compliant, that may be an indication of early financial problems—especially if it becomes a trend.

12. Delinquent Taxes and Employee Withholding

If a company is not paying its taxes, that is almost always a sure sign that it is having significant financial problems. It is even worse if the company fails to pay employee withholding and instead uses that money for operations, as those funds do not belong to the company.

13. Upcoming Contract Expiration

Even if a company is stable and financially healthy, sometimes a pending future event can cause serious problems. For example, if a pending project or contract that comprises a significant portion of the company’s business is set to expire in the near term, that expiration alone could give rise to significant financial problems if the company cannot successfully replace it, downsize, or pivot.

14. Upcoming Lease Expiration

Similarly, if the lease for a company’s only or major facility is set to expire, there could be serious business disruptions and resulting financial problems if a replacement is not lined up. 

15. Upcoming Maturity

Likewise, the upcoming maturity of all or a major portion of a company’s outside debt financing could seriously impact the company if it does not have a source of repayment or refinancing ready.

Part 3 of this alert series will describe red flags specific to real estate developers, owners, and projects.

The Thought Leadership Committee of Barclay Damon’s Restructuring, Bankruptcy & Creditors’ Rights Practice Area issues alerts and blogs on an ongoing basis to keep clients, colleagues, and friends up to date on important developments in the insolvency space. If you have any questions regarding the content of this alert, please contact the author, Robert Wonneberger, Thought Leadership Committee chair, at rwonneberger@barclaydamon.com, or Janice Grubin or Jeff Dove, co-chairs of the Restructuring, Bankruptcy & Creditors’ Rights Practices Area, at jgrubin@barclaydamon.com and jdove@barclaydamon.com.
 

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