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Several years ago, three young executives, all graduates of a highly ranked MBA program, decided to acquire a trucking company via a leveraged buyout (LBO). They focused on improving the operational efficiency of the business by implementing MBA concepts such as total quality management and just-in-time. Their efforts paid off, and the operating efficiency improved, which was expected to create value for the company in the long run. However, the measures undertaken by the executives were costly, and the executives failed to analyze the company's short-term liquidity needs. It was not until three weeks prior to filing for bankruptcy that the executives and the board of directors realized that the company was running out of cash. How did the executives not foresee the liquidity crisis?
This article examines the warning signs of companies potentially facing financial distress prior to the public announcement of severe financial distress, fraud or bankruptcy. As previously illustrated, these types of events regularly come as a surprise to the stakeholders, who are often unaware of the problem until it is too late. After the fact, the market frequently publicizes warning signs that were either overlooked or ignored, as it is debated whether the financial distress was foreseeable. This article identifies a select, nonexhaustive list of quantitative and qualitative measures that can facilitate detection of current or imminent financial distress.
A warning sign of financial distress is any information or measure that indicates that a company might be at risk of deteriorating operating and financial condition. A warning sign, by definition, does not equate to certainty of imminent financial distress. However, as history shows, a single warning sign can potentially identify a weakness of a company, new trend, irregularity and even fraud that might lead to financial distress. Potential warning signs should be examined, in both the context of the company as a whole and the market in which it operates. Executives, financial analysts, investors, creditors and valuation experts often do not detect, or alternatively elect to ignore, these warning signs until it is too late.
Detection prior to the market announcement leads to more options for stakeholders. For example, stakeholders can liquidate their positions, force a company to divest certain of its assets, initiate an out-of-court restructuring via negotiated new...