Financial symptoms of failure

Using financial ratios to identify symptoms of failure

A troubled company goes through phases - underperformance, early decline and late decline.  These phases can be tracked by means of adverse trends in financial ratios.

Following the triggering of a turnaround, these financial ratios are important to the turnaround practitioner during turnaround situation assessment to ascertain what the turnaround plan should look like.

The first financial sign of trouble is normally declining profitability caused by either declining sales or declining margins.

If not timeously addressed, this lead to declining liquidity and/or declining solvency.

The question is often asked which profitability, liquidity or solvency ratios provide the best indication of the degree of financial distress. 

The answer is the Z-Score, which combines all of these ratios into an overall measure of financial health.

Declining profitability

Problems of a leadership, strategic, financial, organisational and operational nature sooner or later lead to declining profitability unless satisfactorily addressed.

It is useful to separate profitability figures into:

  • Operational figures before the impact of financing decisions (interest) and tax.
  • Bottom-line figures after the impact of financing decisions (interest) and tax.

Low, negative and/or an adverse trend in operating profitability figures (see box on the right) normally represent a distressed situation requiring serious turnaround management action.

If the profit crisis exists at the bottom-line profit level (see sections below) rather than the operating profit level, financial restructuring to reduce the cost of finance may suffice.

A turnaround intervention in a situation of declining profitability can normally still count on cash resources and a fair amount of stakeholder support.

Operating profitability measures

  • Turnover.
  • Operating profit (PBIT or profit before interest and tax).
  • Operating profit margin (operating profit/turnover)
  • Return on capital employed (operating profit/capital employed where capital employed = total assets less current liabilities) - indicating of how well assets are managed.

Net profitability measures

  • Profit after tax (PAT).
  • Net profit margin (PAT/turnover).
  • Return on equity (PAT/shareholders' funds).

The profit crisis is ideally addressed before the the company runs out of cash and become insolvent.

Declining liquidity

Unless timeously stemmed, declining profitability inevitably turns into:

  • Decreased ability to generate cash.
  • A cash crisis.

At this late stage, a company has normally suffered serious damage.  It is unable to meet its financial commitments, has lost stakeholder support, needs funding urgently, and is in serious need of corporate renewal to fix the company.

Unfortunately, it is often only at the stage of a liquidity crisis developing that shareholders intervene in the underperforming or distressed company with serious intent. 

If they are unwilling or unable to do so, turnaround or bankruptcy is triggered by creditors, either lenders e.g. banks concerned about the inability of the business to service loans, or suppliers acting on non-payment of their invoices.

Overcoming the cash crisis is normally one of the most difficult challenges faced by a turnaround practitioner, but the tools to address it forms part of the standard turnaround management arsenal.

Cash flow measures

  • EBITDA (EBIT with depreciation and amortisation added back) - this is a good proxy for operational cash flow - if it is positive it indicates that problems lies with working capital management or gearing.
  • EBITDA margin (EBITDA/turnover).
  • Cash retention (net income after interest and tax before depreciation and amortisation) - an extremely useful proxy for bottom-line cash flow, especially for companies reporting distorted figures through capitalising expenses.
  • Cash retention ratio (Cash retention/turnover).
  • Free cash flow (cash flow after investment in/disposal of assets and movement in working capital, but before shareholder and debt financing i.e. before equity investment, dividends, loans, loan repayment and interest payments) - used in discounted cash flow calculations and to determine debt repayment programmes.
  • Cash flow (free cash flow plus debt and equity financing)

Once in a cash crisis, outside stakeholders intervene - with financial restructuring , turnaround, disposal or dissolution remaining as the only options.

Declining solvency

Declining profitability sooner or later leads to declining solvency (if a cash crisis does not develop first) when liabilities exceed assets. 

A solvency crisis triggers action by banks and other lenders concerned about lack of cover for their exposure.

The key measure used by lenders is gearing (interest-bearing debt/shareholders' funds net of intangibles).  Gearing will also impact on the interest cover (see declining profitability).

Other measures are listed in the sections below.

To effect a turnaround, refinancing / financial restructuring is required as part of a turnaround plan to address the causes of profitability problems that eroded the balance sheet.

Solvency measures

  • Gearing (interest-bearing debt/shareholders' funds net of intangibles).
  • Note that Gearing will also impact on the interest cover (see Debt Servicing Measures).

Debt servicing measures

  • Interest cover (PBIT/interest charge) - indicating the ability of the company to service its interest obligations.
  • Short-term debt cover (short-term debt and interest payable/cash retention) - indicating the ability of the company to service its short-term debt obligations - a useful measure for short-term survivability.
  • Debt cover (interest-bearing debt/cash retention) - indicating the ability of the company to service its debt obligations - a useful measure to predict company failure (but not as good as the Z-Score).

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Financial ratios are useful to identify symptoms of failure.