Know the Signs of a Company in Distress
By Michel Pireupireum
24 Apr 2006 at 08:41 AM EDT
JOHANNESBURG (Business Day) -- Few investors spot the early signs of a company in distress.
Their collapse comes as a surprise to most. Even large shareholders, many of them with an inside track, get caught off guard. Yet, with a little effort, it’s possible to spot a corporate train wreck before it happens.
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Here are some guidelines:
Cash flows: If a company’s cash payments exceed its cash receipts over a sustained period of time, it will eventually need a fresh injection of capital from shareholders or lenders, and if that’s not forthcoming, it can quickly find itself in trouble. Even highly profitable companies that have negative cash flows can end up in that situation — especially when growing too fast.
Whatever the cause, it’s probably wise to steer clear of companies that report negative cash flows for any length of time. The cash “burn rate” is another useful indicator.
Debt levels: High interest repayments place pressure on cash flow, which is worsened in distressed companies — which are also burdened by higher borrowing costs. Theory suggests that conservative investors should treat companies with a debt-to-equity ratio of more than 0.5 with caution.
Share price decline: Almost all corporate collapses are preceded by a share price decline. Unfortunately, knowing the difference between a company on the verge of collapse and one that’s temporarily undervalued isn’t always straightforward.
Profit warnings: While market reaction to a profit warning may appear swift and brutal, there is growing academic evidence to suggest the market systematically underreacts to bad news.
Insider trading: Directors have the most up-to-date information on their company’s prospects. Consequently, heavy selling is often a sign of trouble ahead. Admittedly, insiders don’t always sell simply because they think their shares are about to sink, but it should still give investors pause.
Resignations: The sudden departure of key executives can also signal bad news. Likewise, the resignation or replacement of auditors. It usually means a deteriorating relationship and more fundamental difficulties within the client’s business.
External investigations: Enough said. Even if it does out turn out to be unfounded.
Just as a seriously ill person can make a full recovery and go on to lead a fulfilling life while a seemingly healthy person can drop dead without warning, some very sick companies can make miraculous recoveries while apparently thriving ones can collapse overnight. But, if the warning signs are there, why ignore them?
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