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10 Warning Signs to Help Businesses Avoid Bankruptcy

Bankruptcy can damage a company’s reputation and relationships with customers, suppliers, and investors. Read on for 10 signs of potential trouble.
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The confluence of rising interest rates, surging inflation, and a noticeable uptick in business bankruptcies has injected a palpable sense of uncertainty into the economic landscape. As central banks worldwide respond to inflationary pressures by tightening monetary policy, interest rates are on the rise, impacting everything from mortgage rates to corporate borrowing costs. Simultaneously, the specter of rising bankruptcies among businesses, large and small, underscores the challenges posed by economic upheaval. This trifecta of factors has left businesses on edge as they grapple with the complexities of managing risk and making informed financial decisions. In this climate of heightened uncertainty, adaptability and strategic planning have become paramount for those seeking to navigate the evolving economic terrain successfully.

Bankruptcy is a serious setback for a business as it entails significant financial losses, often involving liquidating assets and the inability to meet creditor obligations. It calls into question the company’s reputation and potentially compromises relationships with customers, suppliers, and investors, making it challenging to regain trust and secure future funding. In addition, bankruptcy can lead to layoffs and employee uncertainty, negatively impacting workforce morale and productivity. It is essential to be proactive in identifying warning signs to help prevent it. 

Here are 10 signs for a business to watch for to help avoid bankruptcy, based on what professionals at FORVIS have observed:

1. Declining Cash Flow

Consistently negative or decreasing cash flow is a significant red flag. If your business is not generating enough cash to cover expenses and debt payments, it is a sign of trouble.

2. Increasing Debt Levels

A growing debt load, especially if it is outpacing revenue growth, can be unsustainable. Watch your debt-to-equity ratio and debt service obligations carefully. Rising interest rates can have a significant impact. When interest rates increase from 3% to 6% on $5 million of debt, the additional interest expense amounts to $150,000 per year, depending on the debt structure. This represents a significant increase in borrowing costs, which impacts financial performance and cash flow. If this hypothetical borrower has EBITDA of $500,000, the debt service coverage ratio (DSCR) with 3% interest rates will be 3.33x. When interest rates rise to 6%, the borrower’s DSCR decreases to 1.67x. It is crucial for businesses to consider and plan for such changes in interest rates when managing their debt obligations.

3. Declining Revenue

If sales are consistently decreasing, it is a clear indicator that something is wrong. Companies need to understand the true cause of declining revenue. Determining whether it is a customer-specific issue, an internal issue, an industry issue, or an issue of becoming irrelevant due to innovation and market change is important. Ultimately, addressing declining revenue is essential for the company’s long-term viability and ability to compete in its industry. 

4. Profit Margin Erosion

Shrinking profit margins can indicate pricing pressures, increased costs, or inefficient operations. Consistently low or negative margins are danger signs. When facing profit margin erosion, a company can consider several strategic changes. First, it can assess its cost structure and seek cost-cutting measures to help improve operational efficiency and reduce expenses. Secondly, it can explore pricing strategies to help increase sales prices or introduce premium products and services to boost margins. Finally, the company may focus on revenue growth initiatives, such as expanding into new markets, diversifying product offerings, or enhancing marketing and sales efforts to help drive top-line growth and offset margin pressures.

5. Loan Covenant Violations 

Commercial bank loan covenants are conditions and restrictions that borrowers must adhere to as part of their loan agreement. These covenants are designed to protect the lender’s interests and see that the borrower maintains financial stability. Some typical commercial bank loan covenants include a DSCR and fixed charge coverage. It is important for borrowers to carefully review and understand these covenants before entering into a commercial bank loan agreement. Failure to comply with these covenants can lead to financial penalties, acceleration of the loan, or other adverse consequences. Borrowers also should negotiate terms that are manageable, align with their business objectives, and consider seasonality factors. Consulting with legal and financial advisors is advisable to help provide a clear understanding of the covenants and their implications.

6. Legal Problems

Ongoing legal issues, such as lawsuits, regulatory fines, or contract disputes, can drain financial resources and damage the company’s reputation.

7. High Employee Turnover

Frequent employee turnover may suggest internal problems, decreased morale, or mismanagement—all of which can impact the bottom line. With the loss of key or quality people, job functions are not met, and the quality of information may decline.

8. Declining Market Share

Losing market share to competitors could indicate a failure to adapt to changing customer preferences or increased competition.

9. Declining Working Capital

A decline in working capital, which is the difference between a company’s current assets and liabilities, can lead to significant financial challenges for a business. This reduction in available funds can result in cash flow constraints, making it difficult to meet short-term financial obligations such as paying suppliers and employees. It also may hinder the company’s ability to invest in growth opportunities, causing potential stagnation or missed expansion chances. Declining working capital can harm supplier relationships and impact the company’s credit rating, potentially making it more expensive to secure future financing. To help mitigate these effects, businesses should proactively manage working capital, optimize cash flow, and seek financial solutions to address shortfalls.

10. Inventory Management Issues

Overstocking or understocking inventory can tie up capital or result in lost sales, both of which can hurt your financial health. Inventory management is vital to a company for several reasons. It helps control costs by minimizing storage and holding expenses associated with excess inventory and reduces the risk of products becoming obsolete. Efficient inventory management helps improve cash flow as capital is not tied up in unsold goods, allowing resources to be allocated elsewhere in the business. Inventory management can enhance customer service by confirming products are readily available, potentially leading to increased customer satisfaction and higher sales and profitability.

It is crucial for business owners and management to regularly review financial statements, conduct cash flow forecasting, and monitor key performance indicators to spot these warning signs early. The Restructuring & Turnaround team at FORVIS, including Certified Insolvency and Restructuring Advisors (CIRA), helps business leaders see their challenges through different perspectives—and move with momentum through complex situations. Our cross-functional team, rooted in deep industry and subject matter knowledge, allows us to understand your organization’s challenges and collaborate with you during times of distress. From a complete business restructuring plan to helping with critical business negotiations—the team at FORVIS can help turn a lack of confidence and viability into new opportunities with tailored solutions designed to help you drive impact and change.

If you have any questions or need assistance, please reach out to a professional at FORVIS or use the Contact Us form below.

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