What causes financial distress?

Several factors can lead to financial distress, including company under-performance, high fixed costs, competitor disruption or a downturn in the economy. And when this happens, it can be all too easy to bury your head in the sand and hope the problem will solve itself.

A company may face financial distress of its own making. It may employ unproductive employees, run high capital projects at the wrong time, take on expensive financing costs or simply have a poor sales and marketing strategy.

Companies may also become financially distressed due to external market forces. For example, disruptive competitors offering better products or services at lower prices. An economic downturn – such as the COVID-19 crisis – is even more likely to bring financial distress.

Distressed businesses will typically see their sales rapidly decline and find suppliers offering less favourable terms. It may become harder to secure financing and employees may suffer from lower levels of morale.

Left untreated, a company in financial distress faces a high probability of bankruptcy. So why risk losing a business that you have put everything into growing?

What are the key indicators?

Having a dashboard of financial indicators can help you monitor the warning signs of overtrading and prevent any long-term damage to your business.

Typical warning signs include:

1. Increasing number of unpaid invoices,
2. Lower revenues, increased costs, lower margins.
3. Declining gross profit margin and operating profit margin.
4. Changes in gearing/leverage and debt/asset cover ratios.
5. Changes in CFADS (Cash Flow Available for Debt Service).

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Team collaboration

When faced with financial distress, it is vital that your key functions work collaboratively together.

Managing Director/CEO

The Managing Director/CEO needs to take control of the emerging situation by validating whether the business can realistically meet debt payments on time and conducting root cause analysis to identify which variables have changed since debt was taken out.

The MD should also understand if the problem is marginal or temporary and if the situation is worsening or improving. Time is well spent evaluating if the problem is due to insufficient growth or over forecasting and validating whether the business would remain viable given a different capital structure.

Finance Director

The Finance Director needs to take responsibility for identifying internal and external solutions to protect cash flow by regularly monitoring and analysing KPI performance against forecasts and reporting this to the MD. The FD should identify key trends and flag problems early to enable remedial actions. Re-forecasting based on current and emerging trends to assess how quickly the business could face serious problems will also become a key area of focus.

Sales and Operations

The Sales and Operations teams need to support the MD and FD by working together to implement remedial actions for performance improvement and re-prioritising high capital activities in favour of more profitable ones.

A key priority for sales and operations will be evaluating marketing strategy, developing the proposition to make it more competitive and identifying cost cutting opportunities across the organisation.

Key points

If the core business remains viable, identify what capital structure the business could support with its current assets and profitability. Evaluate if the gap can be bridged with current capital providers through collaborative restructuring or identify if the business can be refinanced by a more suitable capital structure.

If the core business is viable but over-leveraged, evaluate what recapitalisation options are available and the impact each has on existing debt repayment and owners’ equity. Finally, evaluate whether the situation requires pure debt restructuring or if major operational changes will also be needed.

I hope this article has provided some useful tips on what happens when a company is in financial distress and how your teams should work together to avoid bankruptcy.

We work with growing UK SMEs and small-cap PLCs that have funding needs in excess of £2m and regularly approaching £100m. Our clients’ needs will typically be for sophisticated finance products such as cash flow based lending or private equity investments. Our value lies in helping clients access funding that relies on confidence in future trading and cash flows. For a confidential, independent, no obligation discussion on the funding options available click the 'Let's chat' button.