How lenders can spot the signs of distress

Looking back on 2019, it is hard not to reflect on the number of insolvencies and administrations that materialised across the UK economy.

While sectors like retail, construction and care continue to struggle for their own systemic reasons – be it changing consumer demands or low margins providing minimal room to manoeuvre – the health of the wider UK market is generally less turbulent than it might appear.

In fact, while we have seen an uptick in insolvencies since 2016, despite recent uncertainty the level of businesses going under remains far lower than the peaks we saw 10 years ago, in the aftermath of the financial crisis. But, nonetheless, risks remain – documented by a 0.4% rise in insolvencies in the last quarter.

SMEs at greatest risk

As someone who advises banks on the level of risk associated with lending to businesses, I see day-in-day-out the types of red flag that cause most alarm and clearly indicate that a company may be showing early signs of distress. This is particularly important when dealing with new businesses given the increased risks of failure – a quarter of businesses that fail do so within the first three years of trading, making lenders understandably more cautious when looking to support businesses in their infancy.

Lenders will look for four tell-tale symptoms of financial distress in their initial assessment.

1. The first is deteriorating results, be that a decline in sales, significant ‘exceptional’ costs, late accounts or adverse performance against budget.
2. Against the balance sheet they’ll look for issues such as increasing working capital requirement, creditors increasing faster than business growth, and poor credit control.
3. Cash flow is also a major ‘tell’ with tight overdrafts, time-to-pay agreements with HMRC, and borrowing from tertiary funders (particularly if from a number of them) all likely to raise alarm.
4. Operational factors should be considered as well when assessing when a business might be in, or heading for, distress. Has the business recently lost its credit insurance, had difficulties fulfilling orders on time or to the expected quality, and is management time being taken up fighting fires or managing stakeholders?

More anecdotally, there are other warning signs to look out for – ones that you’re likely to have a gut feeling about. Whether that is the company being run as a ‘lifestyle’ business, or an excessive focus on outward appearance rather than concentrating on internal issues.

Why businesses fail

In my experience, poor management is the number one reason why most businesses fail, ahead of finance issues and external factors such as loss of market share, bad debts or the domino effect.

In assessing management capability, there are a number of key questions to consider. Are management too inward looking or focused on the past? Is there sufficient visibility and understanding of the business’ working capital cycle? How engaged are the board of directors and is there a fully worked up strategic plan in place?

As insolvency practitioners, we often see businesses whose challenges have become insurmountable. However, with the right support, and the right approach to funding, it may never need come to that.

First published in NACFB’s Commercial Broker magazine in January 2020.