Weak financial performance can cause borrowers to default on loans. So, it's important for lenders to recognize the early warning signs that a company is underperforming. Often these are nonfinancial cues that raise a red flag before problems show up on the financial statements.
Employees or executives jump ship
Employee turnover — at all levels — often precedes weak financial results. One obvious reason is layoffs: Companies that can't meet payroll may need to shed costs and dole out pink slips.
Another reason is that company insiders are often the first to know when trouble is brewing. For example, if the plant manager's innovative ideas are frequently denied due to lack of funds or if employees hear shareholders bickering over the company's strategic direction, they may decide to seek greener pastures.
The reverse happens, too. Sometimes charismatic "key" people leave the company, which, in turn, causes sales or productivity to nosedive. Given time and sufficient effort, most established companies can recover from the loss of a key person.
Employee turnover can also be a vicious cycle. Top performers in an organization may respond to perceived financial problems by moving to healthier competitors. That leaves behind the weaker performers, who must train new hires on the company's operations. Finding and training new workers can be time consuming and costly, compounding the borrower's financial distress.
If you notice that a borrower's management team is in flux or the owner starts complaining about staffing issues, step up due diligence. Also be on the lookout for key people who are dissatisfied, in poor health or nearing retirement.
Accounting changes hands
Likewise, accounting firm turnover can signal problems. Before signing an annual engagement letter, your borrower's accountant considers potential conflicts of interest and other risk factors. If the accountant suspects aggressive accounting tactics or going concern issues, he or she has an ethical obligation to issue a qualified audit opinion or to terminate the relationship.
Be skeptical any time a borrower switches to a new accounting firm, especially if the previous accountant started work and then unexpectedly pulled off the engagement. Sometimes, a borrower switches accounting firms to save professional fees or to obtain a fresh perspective. But occasionally it foreshadows negative financial results.
Receivables and inventory issues arise
When accounts receivable turnover slows dramatically, it could signal weakened collection efforts, stale accounts or even fraud. For example, a borrower who's desperate to boost sales might solicit business with customers that have poor credit. Or one of a borrower's major customers might be underperforming and it's trickling down the supply chain.
To compute the average collections period, divide the average accounts receivable balance by the company's annual sales, and then multiply by 365 days. If this metric is getting higher — say, 60 days this year compared to 50 days last year — it warrants a discussion with your borrower.
Likewise, beware of deteriorating inventory turnover. Similar to receivables, a buildup of inventory on a borrower's balance sheet could signal inefficient asset management. Certain product lines may be obsolete and require inventory write-offs. Or a new plant manager might overestimate the amount of buffer stock that's needed in the warehouse. It might even forewarn of fraud or financial misstatement. Whatever the cause, always ask questions when days in inventory increases or when inventory as a percentage of total assets starts to rise.
Read the writing on the wall
Lenders often feel like they're the last to know about a borrower's financial distress. While you can't automatically assume that a borrower with one (or more) of these "turnover" issues is on the verge of default, it should raise a flag that stronger due diligence is needed.
Weak results warrant extra attention
When a borrower's financial performance falls short of expectations, it's smart for lenders to conduct additional due diligence to better understand the source of the problem and then monitor interim results. If the company remedies the situation or there's a simple explanation, there may be no reason to panic. But if the borrower can't get the situation under control and is on the verge of violating a loan covenant, you may need to call the loan to protect your portfolio from default.
But how can lenders gauge which borrowers are salvageable? Many lenders request that borrowers hire a CPA firm to perform an "agreed upon procedures" engagement that targets the questionable aspects of the financial statements.
These engagements use similar procedures to an audit, but on a more limited scale. Before work begins, the CPA meets with the client (or the bank) to define the scope of the engagement and select the specific procedures to be performed. For example, you might ask an accountant to independently count a company's inventory and reconcile that count to the borrower's financial statements.
After the agreed-upon procedures have been performed, the CPA will present his or her findings to your bank. Then, it's your responsibility to decide whether to stay the course or call the loan based on the added level of review.