What They Are, Causes, & How to Avoid Them
Financial crisis occurs when a business is unable to meet its financial obligations, including payment of salaries, acquiring inventories and supplies, or settling short-term financial obligations when the need arises. Such a financial situation can impair the ability of a company to take advantage of market conditions or operate on a going concern basis. Financial crisis does not happen overnight, rather it builds up gradually. The smartest CFOs and finance professionals know how to read between the numbers and take proactive steps to avoid disastrous financial outcome.
Outlined below are some of the financial and non-financial red flags to watch out for and how to avoid them:
Financial Red Flags
(i). Declining Gross Profit Margin
What this means: Input costs such as raw material, labour, overheads, etc are rising at a faster rate than revenue. When this happens, gross profit will be shrinking.
Causes: Poor pricing strategy, inefficient production, wastage, and spoilage.
What to do:
- Determine product, service, or segment contribution margins to identify the loss-makers
- Ensure judicious and efficient use of production inputs
- Reduce overhead costs and avoid wastages without compromising quality.
(ii). Liquidity Problem
What this means: This stems from the inability of a company to pay salaries, acquire inventories and supplies, settle short-term financial obligations as they become due.
Causes: Poor working capital management, economic downturns, poor management oversight, under capitalization (overtrading), market gyrations, economic and political instability, etc.
What to do:
- Ensure effective and efficient management of each component of current assets and current liabilities
- Monitor and control cash flow of receipts and payments
- Invest surplus funds in short-term marketable securities e.g. treasury bills
- Strike a balance and design suitable credit terms for your customers
- Offer trade discount to encourage early settlement
- Avoid delaying payments to vendors or suppliers
- Automate invoice processing.
(iii). Inventory is Increasing Without Sales Growth
What this means: Inventories are not converted to sales as expected.
Causes: Poor planning, overproduction, stock obsolescence, low customer demand or patronage.
What to do:
- Implement inventory turnover ratio tracking
- Ensure periodic stock aging reviews
- Engage in aggressive marketing to improve sales
- Encourage early payment discounts
(iv). Increasing Debt and Repayment Problem
What this means: More borrowing and inability to pay when the need arises. This makes a business susceptible to high interest rates, undue pressure, and potential dilution of ownership structure.
Causes: Over-reliance on debt financing, declining revenue, high debt-to-equity ratio, poor cash flow management, lender restrictive covenants, macroeconomics factors such as high interest rates.
What to do:
- Understand total debt structure, including the principal, coupon rates, maturity dates, restrictive covenants (if any)
- Perform periodic debt service coverage and gearing ratios
- Communicate and negotiate debt restructuring early to ease cash flow pressure
- Prioritize debt repayment to enhance creditworthiness
- Improve cash flows
- Engage financial advisor to provide requisite guidance on financial strategy and debt management.
(v). High Debtors Collection Period
What this means: Sales are made on credit, but customers are not paying on time, leading to liquidity problem. This increases credit risk.
Causes: Too liberal credit terms, poor cash flow management, lack of proactive measure to collect receivables.
What to do:
- Offer early payment discounts to customers
- Tighten credit policies
- Improve collection processes
- Use the service of a debt factor or debt collection agent
- Compare your debtor collection period with that of your comparable companies in the industry to set realistic goals.
(vi). Inaccurate Budget and Forecast
What this means: This arises when the actual results are different from the budget estimates.
Causes: Poor financial planning, unrealistic assumptions, and poor budget execution.
What to do:
- Ensure financial data are reliable and accurate
- Thoroughly scrutinize all relevant assumptions to ensure they are realistic
- Leverage technology to ensure standardization and improve data analysis and key performance indicators
- Set clear roles, foster collaborative culture, and provide training
- Regularly monitor actual performance with the budgeted figures and forecast to enhance decision-making.
Non-Financial Red Flags
(vii). Low Employee Morale
What this means: Employee lacks motivation and dissatisfied with work leading to absenteeism, low productivity, and high turnover rates.
Causes: Ineffective management, lack of recognition, poor rewarding system, lack of growth opportunities, etc.
What to do:
- Set clear expectations and goals
- Gather employee feedback
- Track HR metrics, link them to financial KPIs, and flag abnormal patterns
- Encourage open communication
- Create a positive working atmosphere
- Pay liveable wages
- Reward exceptional performance and behaviour
- Encourage openness and respect for all
- Promote inclusion and diversity
- Provide equal opportunity to thrive in the workplace
- Promote teamwork and collaboration
- Offer training and opportunities for employees to expand their skills and grow their careers
(viii). Loss of Confidence
What this means: Suppliers, customers, and investors are not satisfy with the company’s performance, leading to strained relationships, strict credit terms, lack of patronage, and withdrawal of investments.
Causes: Poor performance, constant delay in payment, and lack of trust.
What to do:
- Monitor credit terms utilization
- Foster open communication with relevant stakeholders
- Improve customers satisfaction and experience
- Build trust and relationship
- Prioritize key supplier relationships
(ix). Over-Reliance on Few Clients
What this means: This is a business risk where significant revenue or profitability of a company depends heavily on few customers. This can have financial repercussions and make a business unduly vulnerable.
Causes: Lack of, or inadequate marketing and sales efforts, too comfortable with big clients, lack of capacity to serve many clients at once, and weak strategic planning.
What to do:
- Build recurring revenue streams
- Diversify client base
- Strengthen client relationships
- Increase marketing and sales efforts
- Create cash reserves and flexible operations in case of sudden loss of client.
(x). Weak Corporate Governance
What this means: This is one of the root causes of financial distress in many organizations.
Causes: Poor oversight and accountability, board’s risk blindness, corruption and fraud, strategic missteps, erosion of stakeholder confidence, unhealthy company culture, regulatory breaches and penalties.
What to do:
- Strengthen the board of directors by appointing competent, independent, and diverse individuals with requisite experience
- Establish robust internal controls system
- Foster open communication with relevant stakeholders, including shareholders, employees, regulators, and creditors
- Develop effective risk management framework
- Ensure transparency in financial reporting
- Promote ethical culture and leadership.
In Summary
When a company is struggling with operational and financial obligations, or the financial performance of the organization is on a downward trend, or maybe its profitability ratios, including return on capital employed, profit margin, or return on asset are constantly declining, it is a red flag to financial distress. Actions need to be taken quickly to avoid a corporate catastrophic outcome.
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