Many businesses are only a few short steps away from financial disaster due to their economic structure. If they haven’t managed their risks appropriately, it takes only one or two things to go wrong for the business to collapse. A company in financial trouble will have one or more of the signs warning you of problems ahead. Some of these signs that won’t make the press, we discuss below.
Reliance on Major Customer
The first risk is being dependant 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-1990s, Marks and Spencers dropped its “Made in Britain” policy and decided to source clothes from Asia. They terminated William Baird’s contract, which meant fourteen factories were closed, and Britain lost over four thousand jobs. William Baird sued but lost their case.
Poor Liquidity
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 (bills due within 12 months), and current assets are made up of cash at hand and account 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 one and, in some industries, relatively higher than that. But a borderline company 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.
We have a couple of articles that look at liquidity ratios in more detail. The first article reviews the current ratio, as we discussed above. The second article takes you through the quick ratio; an even stricter measure of a firm’s ability to pay its bills.
High Gearing
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 relies more on debt funding than shareholders funds—the greater the amount of debt a company carries, the greater its finance costs. In boom times, a business can survive with a high gearing ratio, but the ongoing costs of servicing debt can send a company into bankruptcy in a recession. If the debt is short term, and its term ends within a few years, and there are no assets to repay it, the business is also vulnerable.
We have a further article looking specifically at the gearing ratio, a measure analyst would use to measure this risk.
Thin Gross Margins
Businesses operating with thin gross margins are also at risk, especially if their goods come abroad. It takes just a few small currency disasters to wipe out profitability. For example, the currency exchange rate moving unfavourably, making the cost of goods a bit more expensive, combined with a competitor launching a price war, which means the business can’t pass its exchange rate costs to customers, will wipe out the margins.
If you would like to read more on the gross profit margin, check out our article here.
Final Comments
A lot of these risks creep up on companies. The owners and managers are usually too busy handling day-to-day problems even to notice until it is too late. However, a good analyst should be able to spot these signs, telling them a company is in financial trouble.