Clouds on the Horizon: Reading the Signs of Financial Distress

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Most companies face obstacles at various times. The long list of possible obstacles includes one-time items, such as volatile energy prices and business interruption due to weather or strikes. Most of these obstacles only temporarily impact the business’s operating performance as things soon (hopefully) return to “normal.”

When the problems are more serious or long lasting, there is often a reduction in the cumulative cash flow generated by the company, and the impact spreads from the income statement to the balance sheet, causing distress. If not adequately addressed, these problems can further extend into deeper balance sheet distress and ultimately may result in shareholder litigation restructuring and even bankruptcy.

While there are many strategies for addressing distress, nothing happens unless and until there is an internal recognition that the company is experiencing distress. This acknowledgment is the first brick in the path to solutions. Below are some of the signs that create a call for solutions to financial distress.

Stress

In financial stress, the income statement is the most impacted by the challenge, along with equity value. Financial forecasts are missed (sometimes due to temporary/single issues):

Stock price decline
Bad press about financial performance
Potential calls for management or board-level changes

Early Distress

Early distress begins as the cumulative impact of income statement challenges adversely impacts the balance sheet (especially funded debt) as described below:

Bonds are downgraded and trade at lower levels/higher yields
Lenders and other capital providers begin asking pointed questions
Leverage metrics begin to deteriorate, and the company may initiate amendments to debt agreements

Distress

In distress, problems often compound and affect the balance sheet, as shown below:

Bond or other debt trades at a discount
Auditors focus more sharply on providing a clean audit opinion
Management disclosures on the adequacy of capital in public financial statements
Further erosion in enterprise value, including a decline in debt prices
Restructuring advisors begin soliciting the company and its creditors to provide advice
Management retention and replacement/recruitment becomes an issue

Harder to sell products for big-ticket items or in situations that require long lead times

Deep Distress

If distress continues, it can lead to deep distress as the situation becomes urgent and requires extreme action to resolve, which may include:

Covenant breaches and the prospect of default
Limited or no access to capital
Liquidity challenges
Management and board retention
Litigation
Lost contracts
Workforce culture and market reputation

Best Practices

As the signs above appear, some best practices include:

Recognize, acknowledge, and diagnose the distress. The root cause often provides insight into solutions.
Consider all the resources of the corporation to develop potential solutions to the issues that are causing or contributing to the distress.
Determine what stakeholders may be necessary in the resolution.
Discuss at the board level the resources the company has to implement various solutions.
Does your board and management team have experience in these situations or should outside advisors or independent directors be added?
Discuss and implement at the board level a plan for accountability, monitoring, and implementing the solutions to distress.
Discuss at what point more radical action may be required and what resources may be necessary in that pivot.
Understand liquidity; especially as distress deepens, the likelihood of compounding problems grows, and having a high-quality 13-week cash flow forecast can give vital insight into how much time is available before a liquidity crisis may occur.
Process in distress matters. Consider that in extreme circumstances, the board’s and management’s actions may be viewed later by creditors and other stakeholders focused on finding faults or indefensible judgments.

Consider outside perspectives and be open-minded.

WHITEPAPER: HOW TO TALK ABOUT FINANCIAL DISTRESS IN THE BOARDROOM

It can be hard to admit that an organization is facing financial difficulties. Many leaders and board members may want to avoid this topic, but having a candid and thoughtful conversation early on could be the key to saving your company. Download our whitepaper, How to Talk About Financial Distress in the Boardroom, for suggestions on navigating this difficult topic in your organization.

Steven Strom

Managing Director at Odinbrook Global Advisors

Investment banker, board member and expert witness with more than 30 years of experience in advising companies, creditors and other stakeholders in special situations, business transformation and financial distress.