Financial Ratios to Spot Companies in Financial Distress

Following every bankruptcy, a company's investors, suppliers, customers, and employees invariably ask themselves: "Could we have seen it coming? Could we have predicted that the company was in big trouble? Were there distress signs that we missed?"

Often, the answer is yes. There are many early warning signs that indicate that a company is experiencing problems. Being aware of these signals can help prevent losses. If a company is in trouble, odds are that you'll see red flags in its financial statements. At the same time, watch out for changes in its management activities and operations.

Key Takeaways

  • There are many warning signs present when a company is in distress, and most can be found in its financial statements.
  • Sustained periods of negative cash flows (cash outflows exceed cash inflows) can indicate a company is in financial distress.
  • The debt-to-equity ratio compares a company's debt to shareholders' equity and is a good measure in assessing a company's debt default risk.
  • Audits of financial statements often uncover warning signs.
  • Business and managerial changes, such as a deviation away from a traditional business model or the sudden departure of key management personnel, can also signal signs of distress.

Financial Statement Warning Signs

You can learn a lot about a company's financial health from its financial statements.

The first places to look for trouble signs are in the cash flow statements. When cash payments exceed cash income, the company's cash flow is negative. If cash flow stays negative over a sustained period, it's a signal that its cash could be running low and is insufficient to cover bills and other obligations. So keep an eye on changes in the company's cash position on its balance sheet. Without new capital from equity investors or lenders, a company in this situation can quickly find itself in serious financial trouble.

Remember, profitable companies sometimes have negative cash flows and find themselves in distress. Long delays between the time when the company spends cash to grow its business and when it collects cash receivables can severely stretch cash flow. Working capital may also decline and become negative as accounts payable grow at a faster rate than inventory and accounts receivable. In any case, negative operating cash flows, period after period, should be interpreted as a warning that the company could be headed for trouble.

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

The debt-to-equity ratio is a handy metric for gauging a company's debt default risk. It compares a company's long- and short-term debt to shareholders' equity or book value. High-debt companies have higher D/E ratios than companies with low debt.

Auditing Warning Signs

Don't forget to cast your eyes on the third-party auditor's report, usually published at the front of a company's quarterly and annual reports. If the report makes a mention of discrepancies in the company's accounting practices—such as how it books revenue or accounts for costs, or questions the firm's ability to continue "as a going concern"—regard that as a red flag.

What's more, notification of a change in auditors mustn't be taken lightly. Auditors tend to jump ship at the first sign of corporate distress or impropriety. Auditor replacement can also mean a deteriorating relationship between the auditor and the client company or perhaps more fundamental difficulties, such as strong disagreement over the reliability of the company's accounting or the auditor's unwillingness to report a "clean bill of health." Recent academic studies find that there are more auditor resignations when litigation risk increases and a company's financial health is deteriorating—so watch out for them.

The downfall of American energy and commodities company Enron and its auditing firm, Arthur Andersen, prompted the creation of the Sarbanes-Oxley Act's Public Company Accounting Oversight Board (PCAOB), which governs accounting firms acting as auditors of public companies.

Business and Management Warning Signs

While the information found on financial statements can help gauge a company's health, it is important not to ignore managerial and operational signs of distress. Many private companies do not disclose financial statements to the public; as a result, business information may be all that's available for assessing their well-being.

Look out for changes in the market environment. Often, they can trigger—if not cause—deterioration in a company's financial health. A downturn in the economy, the appearance of a strong competitor, an unexpected shift in buyer's habits, among other things, can put serious pressure on a company's revenues and profitability.

Unless these problems are effectively managed, they can be the start of a downward slide in the company's fortunes. Be aware of the company's customers, competitors, market, and suppliers, and try to stay in front of any changing market trends.

Be wary of dramatic changes in strategy. When a company drifts away from its traditional business model, the company might be in financial trouble. Consider a 100-year old company positioned as the global leader of a certain widget shifting its central focus to produce a different, unrelated product. This shift could indicate a problem within the company.

When a company suddenly starts slashing prices, you should ask why. It may mean that the company is in a big rush to increase sales volume and get more cash into the business, regardless of the potentially detrimental impact of such a move's long-term impact on profits or its brand. A desperate grab for cash—also witnessed when companies suddenly start selling off core business assets—could be a sign that suppliers or lenders are banging at the door.

Another sign of distress is product and service quality deterioration. Naturally, a company that is fending off bankruptcy will have an incentive to cut costs, and one of the first things to go is quality. Look for the sudden appearance of shoddy workmanship, slower delivery times, and failure to return calls.

Lest we forget, the sudden departure of key executives or board directors can also signal bad news. While these resignations may be completely innocent, they demand closer inspection. Warning bells should ring the loudest when the individual concerned has a reputation as a successful manager or a strong, independent director.

The Bottom Line

Typically, when a company is struggling, 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 be alert to unusual activities.