ICYMI – Article originally appeared in 2015…. updated and revised for 2018! While getting my daily dose of Quora this morning, someone posed the question “What are the Top 5 Questions a VC should […]
Deal Academy:
Valuation Tips for Identifying Financial Distress
in an Uncertain Economy
We’re in a bit of an uncertain economy, aren’t we? Some sectors are on fire, other’s seem sluggish. With the election cycle in full swing, economic indicators bouncing around, and questions as to where we are in the economic cycle, it makes sense to cast a critical eye towards potential business acquisition loan candidates.
Identifying Financial Distress
Who wants to waste time on a deal that plods along for months but ultimately doesn’t close? We all want to close more deals- and having a full pipeline is the surest way to get there. But wasting time on deals that will ultimately go off the tracks in underwriting or valuation dilutes your ability to focus on the gems.
Instead, let’s help you focus on those top contenders.
With the economy steaming ahead it’s easy to assume that deals only have upside. But as a banker, analyzing the financial stability of a business loan applicant is a critical skill. Using that skill to separate the good from bad is a great way to fill the pipeline with “top talent.” It is important to quickly identify red flags that a company is in financial distress. This financial distress is often as a result of external factors in the uncertain economy that affects us all. In valuations we see a lot of patterns and frequently see five conspicuous areas that indicate a company may be in financial distress at the hands of the larger uncertain economy:
- Accounts Receivable- Unusual activity in accounts receivable can be an early sign that there is a problem on the horizon. If a company's customers are extending their terms, seen as a rise in the number of days sales are outstanding, this may indicate that there is a problem with cash flow on the customer’s end. If the customers are experiencing cash flow problems this is going to trickle down and affect the company at hand as well.
- Backlog/Pipeline- If a company uses backlog as a measurable and meaningful metric, than this also means it is incredibly important to keeping future work flow happening. When a company shows deviations- specifically declining numbers- from historical backlog and quote-to-win ratios this will result in a downturn that will eventually impact booked revenues.
- Key Management Departures- Many small businesses are owner or family operated, so you will unlikely see the departure of the primary shareholder even in the case of financial uncertainty. It’s their business and they are in it come what may. It follows that a departure of key management as a sign of financial distress. Those who serve as the insiders and know the business well are also unlikely to walk away barring some sort of economic disturbance. If someone who is heavily invested in the operations of the company departs it is a good idea to take a closer look at why. Likely they know something that you haven't uncovered yet.
- Declining Gross Margins- Gross margins are often the best reflection of a company’s ability to differentiate their product or service in the marketplace. In most cases we see consistency over time in gross margins of a company. However, it is the nature of business to compete to win bids. Company management will often cut into the margins to win business, specifically when the sales pipeline is drying up. Being competitive with pricing is seen as a better alternative than losing the bid entirely, especially when management is looking to cover overhead costs. The problem arises when you see a company consistently tightening margins to make sales. This often indicates a larger problem at hand.
- Late Tax Filings- Filing later and later each year can be a normal trend as a company grows and becomes more complex and more profitable. However, unusually late filings and a decline in the preparation of financial statements raises the red flag for financial distress. When a company downgrades from an audit to a prepared statement it is certainly wise to wonder what caused that decision. Likely it is cost or a change in the financial stability of the company- and either way it is a warning to look closer.
As a commercial lender, digging deep into the financial analysis of a company from the onset can uncover these and other indicators that the uncertain economy is wreaking havoc on an unassuming client’s small business. Being able to quickly identify these red flags can protect both lender and business owner when proper measures are taken to ease the financial distress and reverse the damage. While some deals mandate engaging an outside valuation, even in situations where it isn’t a requirement it can be a method to thoroughly vet risk exposure – especially in an uncertain economy.
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