What do we understand by financial stress? It essentially boils down to issues pertaining to liquidity. The company does not have cash to meet its regular payments. This could be due to a variety of reasons. It could be due to delays in collections, which is a common problem among many SMEs. It could also be because the debt burden is too high and the cash flows are not able to service the same. Lastly, it could be also because the core operations of the company are going through a down cycle and that is hurting the company. The question, therefore, is if there are signs of financial distress in a company? What are the latent and patent indicators of financial distress in a company? Above all, how to deal with a company in financial distress?
6 Signals that a company is under financial stress..
There are various signals of a company under financial strain but there are some obvious signals if you were to look back at the cases of companies in India…
1. Companies are starting to tamper with the financial statements and that is not a good sign. Look at the case studies. Satyam was misrepresenting its cash in bank. Enron was hiding its real losses in the form of contingent liabilities. Gitanjali had been showing fictitious sales all along. Under the normal course of events the promoters can afford to give out the real picture. After all, the markets do place a premium on honesty and transparency. When companies fudge accounts it is because the real picture is so murky that they cannot afford to make it evident to others. Take that as a warning signal.
2. The company is beginning to compromise on quality. You first find the shift in the quality of packaging and then in the quality of products. You can make out from how the company treats its employees and its customers. When the company goes out of its way to cut corners and starts actually compromising on quality, you can be sure that the company is in real financial stress.
3. Is the company having a negative free cash flow? Profits and losses are one side of the story. There is something called the cash flow account which depicts the cash position of the company and whether it is generating genuine cash. Companies have to necessarily generate positive cash flow from operations which will be used for investment purposes and for financial loan repayments. When the company shows negative free cash flows from operations and is using borrowings to bridge that gap, you can be dead sure that the company is in real deep financial stress.
4. Look at the debt on the balance sheet. There are 3 things to look at here. Firstly, is the long term debt rising and is it being actually used for short term allocations. That is not a good sign. Secondly, look at the cost of debt that the company is raising. If the company is raising debt at higher cost then it is desperate and that is a sign of financial stress. Thirdly, check if the company is using its long term debt to finance its short term liabilities. This is a recipe for an asset-liability mismatch.
5. Look carefully at the margins story. Normally, when a company is under financial stress you can see it in the margins. You can look at the net margins and more importantly at the operating margins. That is a classic giveaway that the core operation of the business is under stress. Consistently lower operating margins means that either the sales are falling faster than costs or the pricing power is lost. Either way it is only going to accentuate the financial stress of the company.
6. Is the company changing its auditors rapidly and also losing its key employees? That is not a very good sign. Probably, the auditors are not pliable and are unwilling to play ball to hide the financial stress. Probably, employees are not too convinced about the financial stability of the company and their own futures. All these are giveaway signs that a company’s financials are clearly deteriorating.
7. Here is a bonus indicator! Thanks to the World Wide Web, not much can be hidden from the public eye. Check out the net and other discussion forums for updates on the company’s performance and products. If you look at any of the financially stressed companies in the market you will find that the warning signals were already there in these discussion forums well in advance. You need not take this feedback at face value but there is rarely any smoke without fire.
As we said earlier, when a company is in financial stress it is not the end of the road. On the contrary, if the warning signals are heeded well in advance the promoters can take corrective action. But if the promotes are trying to sweep the truth of financial stress under the carpet, that is when you need to turn cautious as an investor.