Identifying early signs of distress and taking action

October 2021  |  SPECIAL REPORT: RESTRUCTURING & INSOLVENCY

Financier Worldwide Magazine

October 2021 Issue

Anybody using social media will have seen ‘Top 10’ lists. They have been applied to almost everything, including signs of business distress. Most top 10 signs of distress will list such things as declining revenues, making losses, arrears on supplier and HMRC payments, increased borrowing, and poor management information. All valid but not, in our opinion, early signs of distress. By the time such signs are evident, it may already be too late to avoid a liquidity crisis.

Distress and insolvencies are only ever caused by a lack of cash. An oft repeated adage is that ‘sales are vanity, profit is sanity and cash is king’. There is certainly a lot of truth in that, but how do you spot the early signs of weakening cash flow? The key is to have a deep understanding of your business’s cash flow and how it will be impacted by changes in business activity and events in the market.

Many businesses start the slide into distress with a reduction in sales. Maybe the whole market is down, there is a new competitor or they have lost a customer. Counterintuitively, that frequently leads to a one-off cash boost as cash tied up in working capital is reduced and creates a false sense of security.

Management must understand their cash flow and be able to quickly assess the cash impact of significant changes to their business. Most managers understand the concept of profit but find it much harder to understand cash flow. It is less intuitive. It is often delegated too far down the management chain and overlooked by senior management who see it as an outcome rather than something that can be managed. Distress often gives them a crash course in cash management, but it would be far better to be aware of liquidity constraints beforehand. Those businesses that focus as much on cash flow as profit are far better placed to avoid distress. The best make cash management an integral part of management information systems and build it into their decision making.

In distressed situations, one of the first things turnaround professionals do is implement a rolling 13-week cash flow forecasting system. The reason 13 weeks is used is that it usually approximates the length of a business cycle; the time from a customer placing an order through to provision of the goods or service and eventual receipt of payment. Similarly, for any goods or services bought in, it covers from order to payment. It is also long enough to catch most variations in seasonal patterns, holidays and so on. It is therefore capable of a high degree of accuracy.

It is a very valuable tool, not just for the numbers but because it rapidly becomes the basis for short-term decision making. The chief executive, the board and all functional and local leadership must get involved. Cash forecasting and management is not something that ‘somebody in finance’ does in a silo. Every business decision must have the cash implications clearly understood. Yet, so often sales teams are incentivised to achieve the highest price and procurement teams the lowest price, with neither having any incentive to negotiate the best cash terms even if that means some compromise on price.

Picture a situation at a board meeting where it is reported that the business has won three substantial sales contracts. As a result, the sales and profit targets for the current financial year look to be in the bag. Celebrations all round?

What if the first of those contracts requires significant upfront capital expenditure, the second requires a safety stock to be held as the customer has supply chain concerns and the third is from an existing customer that has the longest payment terms and frequently pays later than terms?

The celebrations could be short lived if by the next financial year, the company is suffering a severe cash shortage and heading rapidly into distress.

Businesses need to become ‘cash savvy’. This happens when they understand their cash flows and what drives them, when they accurately forecast their cash flows and when the business culture considers the cash impact of all decisions. Sadly, many companies go through the pain of distress before they become cash savvy. It is a bit like taking up exercise and a healthy lifestyle after a heart attack. Prevention is much better than cure.

So how does a business become cash savvy? Clearly all businesses are different, so it is impossible to set out detailed steps that will apply universally. However, we can look at a broad roadmap.

Firstly, introduce a short term, 13-week cash flow forecast that is rolled forward and updated weekly. The key thing is to keep it simple. Use the 80/20 rule as in most businesses, 80 percent of cash flows arise from 20 percent of transactions. The rest can just be aggregated. Get everybody into the habit of doing this weekly and when it is rolled forward show the previous week’s actual versus forecast. There can be little excuse for getting the forecast in the first week significantly wrong. Review the forecast at senior management level and ask questions of big changes. Accuracy improves dramatically when people know they will be held to account. Also make sure that the cashflow forecast shows cash versus available facilities. What is the headroom? Are there potential pinch points where cash will be tight?

Secondly, do a deep dive analysis of the main cash cycles in the business. These are the sales cycle from order to cash receipt and the purchasing cycle from order to payment. The whole cycle is often longer than most people expect. Understand how that works through the business. It may be worth looking in more depth at the largest customers or sales channels. Are they uniform? If there are big variations, why? Do the most profitable customers have the best cash flow? Often that is not the case. Similarly, which customers create the most inventory and work-in-progress? Physical inventory is visible, but unbilled labour is not, and work-in-progress is not always obvious. Service businesses often have higher levels of work-in-progress than necessary but do not realise it.

Thirdly, identify all the key decision points that determine cash flow. Who agrees terms for sales and purchases? Who decides inventory levels? Who authorises capex? How are trade-offs between price and cash flow decided? Are such decisions made by senior-enough people with full knowledge of the impact? Do staff need to be educated and given better guidance on such decisions? Do incentives need to be changed?

Fourthly, ensure that cash flow is on the agenda at all important meetings right up to board level. It should be driven by the chief executive and the board. Set key performance indicators (KPIs) and measure performance against them. Get cash thinking ingrained in the business.

All the above are internal, company specific actions. There should be no barriers to putting those ideas into place if there is a will to do so. Lastly, management should look outward at external factors that could impact cash flow. Even the best cash management is not immune to factors outside the company’s control. Management should look at the risks to customers and supply chain. Surveys have suggested that around 30 percent of insolvencies in the UK are due to the insolvency of an important customer. If those give rise to a further 30 percent, then the real figure could be nearer 40 percent. Customers going bust result in a bad debt; cash that will never be recovered. There may be inventory that will never be sold or work-in-progress that cannot be completed and billed. They can also result in the loss of future business, so a potentially huge cash impact.

Credit insurance can go a long way to mitigating such risk but at a cost. A watchful eye on available information, news and so on, can be useful. Staff with customer contact should also keep an ear to the ground for useful insights and gossip where possible. Thinking through how you would deal with a major customer in distress and potential insolvency is also worth planning for. Normally, there will be a period of distress when a customer is slow paying its bills and asks for your help. How would you handle that? Do you know your legal rights and how you can best manage the risk of extending further credit? How can you best protect your position and minimise the impact if that customer does eventually become insolvent?

Often forgotten but important are key suppliers and the risk of their distress or insolvency. Which ones are critical to the business and could not easily be replaced? Could such a failure stop your business, and how can that be mitigated?

Other external factors that impact cash include interest rates and the availability of financing. What would be the impact of a rise in interest rates? What headroom and flexibility do you have on borrowing facilities? A good medium-term financial model that can be flexed as part of a scenario planning exercise is a good way of getting a feel for how resilient the business is to a variety of external events.

If the COVID-19 pandemic has taught us anything, it is to expect the unexpected. The future remains uncertain. The cash flow pressures as we emerge from the last 18 months, together with government support being withdrawn, will result in significant distress and an increase in insolvencies. The best way to avoid that is to be cash savvy and as prepared as possible for whatever comes your way.

 

David Bryan is chief executive at BM&T. He can be contacted on +44 (0)20 3858 0289 or by email: dbryan@bmandt.eu.

© Financier Worldwide

BY

David Bryan

BM&T

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