Lots of businesses are only a few short steps away from financial disaster, due to the way they are structured. If they haven’t managed their risks properly, it takes only one or two things to go wrong for the business to collapse.
Companies that are in financial trouble usually have one or more of the following characteristics.
The first risk is being dependent on just a few big customers, or even worse just one big customer. If that customer takes away their business, or goes bust themselves, it creates a catastrophic drop in revenue. One real life example was the British clothing manufacturer William Baird. For thirty years they supplied the giant retailer Marks and Spencers with clothes.
Over time Marks and Spencers had become their biggest customer. Then in the mid 1990’s Marks and Spencers dropped it’s “Made in Britain” policy and decided to source clothes from Asia. They terminated William Baird’s contract, which meant fourteen factories were closed and over four thousand jobs were lost. William Baird sued, but lost their case.
On a small scale webmasters of small sites, such as this one, are often completely reliant on Google for their advertising revenue. The ads you see on the site are provided in partnership with Google through their Adsense program. In being so reliant on not only the advertising revenue but in addition the ranking within their SERPS (search engine results page) is a very risk heavy model – if only on a small scale. One wouldn’t want to be running a large scale website on that business model.
The next risk is poor liquidity due to current assets not being enough to finance current liabilities when they fall due. Current liabilities are short term debts (obligations due within 12 months) and current assets are made up of cash at hand and accounts receivable within 12 months (i.e. goods for which the business has billed customers).
Most financial analysts calculate the current ratio as current assets divided by current liabilities. A healthy company will have a ratio greater than 1 and in some industries quite higher than that. But a company that is borderline will have a ratio of less than 1. If the ratio is below 1, the company is likely to be in trouble. All it takes is a few bills to go unpaid and some angry creditors. Remember that creditors can request that a company goes into administration to protect their money.
Another indicator of vulnerability is a high gearing ratio. This is the debt in the company divided by the shareholders capital. A high gearing ratio indicates that the business is financed by debt rather than money put in by the shareholders. The greater the amount of debt, the greater the finance costs in the business, because debt has to be serviced regardless of the amount of sales a business does.
In boom times a business can survive with a high gearing ratio, but in a recession, the ongoing costs of servicing debt can send a company into bankruptcy. If the debt is short term, and it’s term ends within a few years, and there are no assets to repay it, the business is also vulnerable.
Gearing in any business is a double edge sword with it providing a means for a business scale and leverage its financial position to take advantage of growth and expansion. But was seen in the financial crisis starting late 2007 and into 2008, leverage accelerates the vehicle down the financial hill too.
Businesses operating with thin gross margins are also at risk, especially if their goods are sourced abroad. It takes just a few small currency disasters to wipe out profitability. For example the currency exchange rate moving unfavorably, making the cost of goods a bit more expensive, combined with a competitor launching a price war, which means the business can’t pass it’s exchange rate costs to customers, will wipe out the margins.
A lot of these risks creep up on companies. The owners and managers are usually too busy handling day-to-day problems to even notice until it is too late. A good analyst however should be able to spot them just by looking at the accounts. For example our recent articles on ROE and ROTA demonstrate the importance these key performance measures in tracking the operating efficiency performance of management.