Private Capital Investing

CHAPTER 13Distress Symptoms and Remedies

EARLY WARNING SIGNALS

Detecting early indicators of distress is critical in order to implement promptly corrective actions. It is often very difficult, though, to distinguish between symptoms and problems, between temporary and seasonal swings, and between permanent and cyclical difficulties.

A preliminary deep dive should always start the analysis of the financial statements: key questions to investigate are whether:

• earnings are being generated from core business;
• accounting policies increased profitability and/or reserve accounts;
• there are continuous changes for restructuring/reorganisation;
• creditors are showing signs of concern;
• bad debts are being written off;
• tax charge is low relative to reported earnings.

The main distinction in symptoms of credit deterioration is between financial and non-financial indicators. The key ones are:

• Financial danger signals:
  • covenant breaches;
  • late submission of financial statements;
  • creative accounting (frequent acquisitions and disposals, deferred consideration, off balance-sheet financings, contingent liabilities);
  • earning enhancements (sale and lease back, asset write down and subsequent profit on disposal, capitalised expenses, accelerating revenue, suppliers' discounts, deferral of costs, sale of subsidiary with recourse).
• Non-financial danger signals:
  • unnecessarily complex corporate structure;
  • board and/or senior management resignations;
  • change in financial year end;
  • change in auditors; ...