Financial Ratios to Spot Companies In Financial Distress

Following every company bankruptcy, 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 a number of 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 good you'll see red flags in its financial statements. At the same time, watch out for changes in its operations and management activities. (For more, see "8 Signs of a Doomed Stock.")

Tutorial: Financial Statements

Naturally, you can learn an awful lot about a company's financial health from its financial statements.

The first places to look for trouble signs are 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 cash in the bank could be running low, so also 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, even profitable companies can 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 from resulting sales 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 combined long- and short-term debt to shareholders' equity or book value. High-debt companies have higher D/E ratios than companies with low debt.

Don't forget to cast your eyes over 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 has the ability to continue "as a going concern" – you should regard that as a red flag that problems are brewing. (To delve deeper into balance sheets, see "Financial Ratios to Spot Companies Headed for Bankruptcy.")

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, and 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.

While information found on financial statements can help with gauging 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, so business information may be all that's available for gauging 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 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 game plan, the company might be in financial trouble. Let's say a company has positioned itself as the global leader in cheap, fast temporary workers for 50 years, and then launches a strategy that forces all salespeople to stop talking about temp workers, and start selling high gross margin permanent placements. There could be a big problem.

Or when a company all of a sudden starts slashing prices, you have to ask yourself: "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: 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.

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. (For more on this topic, see "Unpredictable Event or Bad Investment?")