More Red Flags

We’ve posted several times before about the early warning signs of financial distress, most notably about Borders and about Borders again. With the recent bankruptcy of Toys R Us, this seems like a good time to return to the subject.

Spotting trouble before it becomes calamitous is more of an art than a science. The predictive algorithms haven’t been written yet, so credit foresight remains much more judgment than data-driven. That may change, but for now we stand by our early warning signs: falling revenues, growing losses, increasing working capital, rising debt, decreasing liquidity, and struggling management.

But we don’t have the definitive view. A risk manager we know who works with middle-market companies has his own list, and we thought you would find it interesting. Here are his problem credit red flags.

Pinky rings and airplanes
Management is focused more on status and comforts and less on the business. They’re too busy trying to measure up at the country club and pampering themselves to stay on top of changing market conditions and competitive dynamics. When trouble develops, they’re slow to react.

Third generation in the business
Key managers get their jobs the old-fashioned way, they inherit them. When the grandchildren are in charge and the founder isn’t active enough to make up for their lack of professionalism, the business suffers. Or they’re capable enough, but there are too many of them in the company. When they can’t agree on key decisions and the founder isn’t strong enough to mediate, the business suffers.

“To tell you the truth”
Managers who keep insisting their telling you the truth probably aren’t — at least not the whole truth. Outright fraud is fairly rare, but material omissions are all too common. Companies in trouble need more credit, not less. Managers have strong incentives to hide problems from their bankers.

Former banker
There rarely is a substitute for operational experience and profit and loss responsibility. Bankers understand businesses mainly from a risk perspective and they operate mostly in transaction-by-transaction mode. That is not a strong background for operating a commercial or industrial business.

“Business of the Year”
This is a different indulgence from rings and planes, but it’s a bad sign just the same. Positive press can help a business, no doubt. But seeking attention for a company can be a form of status seeking by managers and a potentially dangerous distraction. When managers worry more about what’s best for them than they do about what’s best for the firm, there is all too often trouble ahead for both.

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