CHAPTER 7 - CHAPTER 11 - BANKRUPTCY
DO YOU KNOW YOUR DEBTOR'S SIGNALS?
(Copyright, 2001-2017, Business Publication Inc.)
How can we tell, in today's business environment, when a company is on the verge of bankruptcy? It is not easy. In fact it is downright difficult.
While twenty years ago it was only necessary to look at a company's financial information and their payments trends to determine if the firm was creeping closer to a bankruptcy filing, today's financial executives need more information. Today's executives need to be able to stay on top of their debtors like never before.
Information, information and more information! That is what is needed in order to be able avoid shipping a debtor that could file a bankruptcy petition tomorrow or several months down the road.
You need to know (and not necessarily in this order):
1) Have any judgements or liens been filed against the debtor?
Judgments can be as insignificant as a $5,000 judgment brought against a company for a customer slipping and hurting himself on the debtor's premises or as important as a $100 million judgment brought against a company for anything from illegal advertising/ marketing practices and defective products to toxic cleanup, etc. Judgments should be viewed in context with the size of the company. A $2 million judgment on a company with $5 million in sales could be catastrophic, however, a $2 million judgment against a $10 billion firm will not affect their bottom line as significantly.
A tax lien however, especially a federal tax lien, could have more severe consequences.
Lets look at the state tax lien first. Some state tax liens are issued for failure to file franchise fees. This is often not as significant as a lien filed against a firm for not pay its sales tax. In fact, any sizable state tax lien (again depending on the sales volume of your debtor) could have a significant impact on the way your debtor would pay you.
Federal tax liens on the other hand are generally larger than state tax liens and often have more of an impact on a firm. The reason they are often larger is because many federal tax liens are often a result of companies failing to pay their 941 employee payroll taxes. These often accumulate to large amounts and by the time the federal government actually attaches a lien against a debtor, often six months or more have gone by since the feds first having notified the debtor they had to pay--and the amounts kept piling up. So by the time the lien is actually filed by the federal government the company can often be in dire straights. Other tax liens, for not paying corporate taxes, 940 taxes, franchise taxes, etc., can at times, also be significant. But the ones that you want to watch out for are the ones that are the larger federal tax liens.
2) Have any lawsuits been filed against the debtor?
Just like judgments, lawsuits can be meaningful or not. A $5,000 lawsuit against Wal-Mart Corps a result of a bar of soap falling off a shelf and hitting a customer in the head is not nearly as significant as a $500,000 lawsuit filed against a biotech firm that has been in business only three years, has little capital and has sales of only $3 million.
Putting the lawsuit in perspective, however, is imperative. Why was it filed ? Who filed the lawsuit? Was it one of its competitors? Was there any type of trademark, copyright or patent infringement? Did a trade creditor file the lawsuit? This is important for obvious reasons because you could be next on the list to not get paid. In fact, when you see several lawsuits being filed against a debtor, look at the most recent financial information. If it contains derogatory information these can be invaluable signals as to whether that debtor is on the verge of filing for Chapter 11 protection.
3) Is the debtor having any inventory control problems?
For some companies a poor inventory turn can be a death knoll.
This of course depends on the severity of the problem however it can certainly have a
significant impact on the company's financial results. Analyzing the company's inventory ratios and comparing it to industry standards is also a useful approach to beginning to understand your debtors inventory situation.
You can get a good idea if the company is having inventory control difficulties by reviewing its purchasing habits on a historical basis. Comparing this with sales and then reviewing your debtor's credit exposure with its primary lenders (and also discussing this information with the debtor's bankers--although in many cases obtaining information from a debtor's lender is like pulling teeth) could furnish positive results. If a retailer, for example, is known to have outdated inventory and their inventory purchases increase so to as include more update inventory, you know two things: the company will discount its own inventory to move it out the door and as a result revenues and earnings will be affected and the company's cash flow will be affected as a result of its drawing on its credit line to purchase newer inventory. This is assuming internal cash flow is not sufficient to handle, carry and pay for old and new inventory.
Its also always worth knowing if the products your debtor has in inventory is simply outdated. Pharmaceutical companies and biotech companies are one example where, if their products are not moved within a specific time period, they will simply have to be discarded. Beyond this, knowing your debtor's products and their shelf life is imperative.
The Bridgestone/Firestone Tire Co. and Ford Motor Co. tire debacle is one of the most recent catastrophic examples of inventory affecting a company's bottom line. The recall of so many millions of Bridgestone tires certainly resulted in inventory problems for both Firestone and Ford. The ramifications of this had a snowball effect causing earnings shortfalls and a number of large charges on their balance sheets.
Some inventory difficulties could be so severe so as to cause a company to consider restructuring its operations or even file for Chapter 11 protection as a result of its inability to pay off its debtload because of its immediate needs to purchase more inventory.
4) Has the debtor's sales declined.
This is often a key. While a sales decline may not be as important for companies that are selling off certain divisions or assets so they can concentrate on their core business
operations, firms that have remained intact but still see their sales decline (especially at greater percentages than the industry they are operating in) should raise a red flag.
Further, look at sales historically. Have quarterly and fiscal sales declined on a steady basis? Or is the decline taking place in a quarter that is known for such declines. The retail industry, as an example, often gets a higher percentage of its sales during the fourth quarter of the year than during the first quarter. The holiday season and the return of merchandise after the first day of the New Year often result in a drop-off in sales during most retailers' first quarters. You should generally, however, be concerned if sales have declined on a year-to-year basis and for the same periods. Smaller companies are obviously affected more than larger companies.
It is also sometimes important to understand the difference between net sales and gross sales.
While knowing the distinction is not always necessary, there are often times that gross sales may not adequately reflect the revenue from the operations of the firm. In fact, the recent trend of companies reporting "pro forma" financial statements and their desire to show their best side, through the use of these statements, has caused many credit/financial executives to be much more cautious when evaluating financial information.
5) Has the debtor's earnings declined, or if a loss was reported in the most recent fiscal quarter or year, has the loss widened from the same period one year earlier.
Just because a company reports a loss does not always mean that it is on the verge of bankruptcy. Similar to what was discussed in declining sales, if there is any decline or loss reported it must be compared with the same period one year earlier.
Many industries have down periods and this should always be taken into account. If it is a down period, how does it compare with the industry's downturn--if there is one. If there is no industry downturn then you should be concerned. If the company has experienced a loss during this down period, does the loss come at a time when revenue has declined as well. If the net loss for the period includes a significant operating loss then you should be even more concerned. Many net losses can be explained through sizable restructuring charges or other nonrecurring charges. Operating losses, however, are a "horse of a different color". Further, when you combine operational losses with revenue declines of more than 10%--this should definitely raise a red flag.
So watch for companies that have operating losses or sizable net losses that continue from quarter to quarter. Watch for companies whose net losses are a sizable percent of sales.
You also have to be aware of the industry your debtor is operating in. In biotech industries or in other technology firms, you may have losses that are significantly higher than revenue. Using pharmaceutical manufacturers as an example, these companies may be awaiting approval from the FDA for a new drug. As such they could be expending money that they obtained through public offerings or other financial backers--yet they're reporting negligible or even zero revenues. In cases like this, it does not always mean that the debtor is on the verge of bankruptcy. What you need to know, in cases like this, is how strong the financial backing is behind your debtor. You may be able to obtain this information by contacting the debtor's primary lenders--whether it be commercial finance companies, venture capital firms, traditional lenders, etc. If the company you are dealing with needs your product or services that badly, then the financial backers of your debtor would want you to know that the company they are putting their money into is solid AND will pay its suppliers.
6) Has there been a recent change in the debtor's management? If so how severe? Has it been a wholesale exodus of top management?
This is always a tough one to gauge. If the company has seen a lot of its top management leave the company within a short period of time you, as a supplier, should be concerned. You should be concerned if the CEO has resigned. If the CFO has left the firm. If the COO has left the company within the past quarter. If the company is changing its board of directors. If management is leaving, for whatever reason, you should be concerned.
If the CEO of twenty years, however, decides to resign for "personal reasons" and the company is experiencing a slight downturn similar to what it experienced in the past--don't jump the gun.
Investigate, investigate and investigate before thinking that the CEO "jumped ship".
7) What's happening in your debtor's industry? Is it positive or negative?
This is always an important one. The resent problems in the airline industry and the recent terrorist attacks have caused not only many layoffs within the industry but concerns among its thousands of suppliers. Wholesale cutbacks are taking place throughout the industry and beyond. Here's an example of why you have to understand industry events and their "ripple affects".
If a company that sells to United Airlines comes to you with a new, sizable order, look at it twice, look at it closely. Who were they getting the products or services from previously? Why did they stop doing business with that company? Was it because they were not paying them and they are looking for new suppliers to also--not pay?
Be aware of not just the industry happenings but also of industries that are cyclical. We mentioned retailing previously. We know that for department stores and discount chains and even the big wholesale clubs, the first quarter of the year is generally the worse for sales.
We know that retailers specializing in selling durable goods (products that will last more than 5 years) are generally hardest hit in an economic downturn. However, keep in mind, there are times where one company in an industry will rise to the occasion and beat an industry or even an economic downturn. These often become the "shining stars" of the industry. Be there with these companies. Often they are the best managed and the most financially sound.
One such example is in the home improvement market. Home Depot started as a small Georgia firm. Even during times of economic downturn it still grew. It grew while many of its competitors were either in bankruptcy or closing locations. Home Depot was a star in its industry and nearly every industry has a star. Know who they are and why they're successful and know the market that they are selling to.
8) If a privately owned firm, with aging management, is there an automatic succession plan in place?
This one certainly requires your investigation skills and your knowledge of the company. If a family-owned business, is the son or daughter in line to succeed the father or mother? If so, what do you know about these individuals. Have either son or daughter worked in the firm? If so, how long? Does he have a solid reputation? In what capacity did he or she work?
All to often, we hear of relatives taking over a business when the founder retires and ends up running it into the ground. While this may not be in the majority of cases, nevertheless to those of us that have been stung by a bankruptcy filing or a liquidation when a relative takes over the helm of the business we always ask ourselves why we did not see it coming. Don't beat yourself up. It's not always black and white.
Not all privately held firms are family-owned. Some companies are owned by a group of individuals that has not taken the company public. It is important to evaluate these owners as well as the company's management. Do they know the industry? How long have they been in the industry? Are the people running the company venture capitalists or financial people who may not know the industry as well as they should? Have they hired qualified management? What is their background? If a venture capital firm or another financial organization is backing this privately held firm you are selling to or are considering selling to, what is their track record?
Are they known for investing in a company and letting it grow or are they known for investing in a company, letting it grow, and then selling off the assets piece by piece?
More often than not, however, when it comes to family-owned firms, a succession plan is imperative--and this is something you should ask for. Remember, you are acting as a bank by extending credit, and any bank would want to have this information.
9) Have there been any layoffs at the company or are there any plans to layoff employees?
When a company reduces its workforce most of the time it is a sign of things to come. Granted when one company purchases or merges with another company there are often duplication of jobs and as a result the workforce is reduced according. This is for efficiency purposes.
However, when such a consolidation takes place it should not be looked upon as "a bad thing". But when a company is having problems and begins to reduce its workforce--even if by five percent--that's something we should be concerned with. And when you combine industry and company trends with the cutbacks, this might be a harbinger of things to come.
In fact, quite often, before a company reports a loss they may announce anything from temporary or permanent plant closings, the shutting down of production lines, freezing salaries or even the laying off an unspecified number of workers. As a result of these cutbacks the company may report restructuring charges that result in losses.
Any such cutbacks should be looked upon by creditors as an attempt by the company to right itself or turn itself around. Any such move is often an attempt to either return to profitability or minimize revenue, earnings declines or even losses.
So, look at any cutbacks at a debtor's operations with a cautious eye. It may be a sign of things to come. But keep it all in perspective. If a debtor simply wants to run its operation "leaner", this could be a good thing. It could mean better cash flow and improved earnings over time.
10) Is the company carrying to much debt? Has the company defaulted on any of its debt or credit arrangements with its lenders?
These are questions that often are difficult to obtain. The reason is that many lenders will not report any defaults until that default is about to take place. Of course, if a public company, the debtor should be reporting their loan or credit line status on their quarterly reports with the SEC. That's why it is imperative to stay on top of a company's lending situation. Be aware of its overall debtload as well as its debt capacity. Know how much the company can handle based on its cash flow and other variables. Stay on top of whether a company is meeting its debt obligations and living up to its credit/financing arrangements with its lenders. Gathering this information may be hard work but it can truly pay off down the road.
Lenders do not always provide easy access to the status of a debtor's financing arrangements.
Often, the only way to be able to get this information is through SEC filings (if a company is publicly-held). It is important to remember that when you are extending credit, if you are a supplier in any way, you are acting as a bank and your debtor's financial arrangements is information you should have access to. Know when the due dates are for any large/balloon payments. Know when the arrangements expire. Know what percentage of credit lines have been drawn down or even used up.
If you are an important supplier this information may be easier to come by than if you are selling something of a lesser significance to a debtor. Nevertheless, it is information that you should, as a supplier, have access to.
11) How much of the debtor's credit line, with its bank and other lenders, has it used up?
This is an important one because it may determine how you get paid. If a company s unable to pay its operational debt (or even long term debt) through its internal cash flow it may be dipping into its credit line arrangements with its lenders. You should know this.
Before this though, you should understand the debtors cash from a historical perspective.
It's also important to know what, if any, form of negotiation is going on between debtor and lender. What are the stages of those negotiations? How long have they been going on? Are the purposes of the negotiations to extend the debtor's outstanding credit line, to reduce it, to increase it or "call it"? If it is for the purpose of calling the credit line then you should find out if the debtor has any or is working on obtaining any additional means of financing. Who is the debtor working with? What is this potential lenders track record?
12) Analyze the debtor's cash flow historically. What are the trends? Is it sufficient?
We have already talked about cash flow throughout this educational series. It can never be overstated, however, the importance of analyzing it and having a complete understanding of a company's cash flow AND comparing it to industry standards. This is important as it is directly tied to the company's profit margins as it affects its operational earnings or losses as well as its net earnings or losses.
In order to completely understand a company's cash flow, however, you have to understand the cyclical nature of both the industry and the company. Are some months or quarters better for cash flow than others? Has that historically been the case?
More importantly is the cash flow sufficient to run the internal and day-to-day operation of the company.
Understanding cash flow from a historical perspective as well as from an industry one will go a long way to helping you notice the signals that a company may display before becoming insolvent or having to file a Chapter 11 petition.
13) Have any of the debtor's management ever been involved with a company that has filed bankruptcy?
The reason for this is obvious, however, be aware of the ease in which a company can file bankruptcy and then, two months later, start up a new corporation. Finding this out can be
difficult. That is why when you ask questions similar to this it is important to have the debtor sign a truth-in-lending notice stating (if this is a question on a credit application or other document) that all the information provided is correct to the best of his knowledge. Certainly, knowing if either the debtor personally filed bankruptcy or was involved with a company that filed either Chapter 7 or Chapter 11 tells you a lot. How many debtors will be honest with you is another story. If you ask them to explain the circumstances under which the filing took place, however, you may get a higher percentage to answer truthfully.
As many of the nation's top bankruptcy attorney's will tell you, it is not unusual to find a company filing for bankruptcy protection only to have its creditor's find out "after the fact " that the principals of the now bankrupt firm are the same individuals that were involved in a Chapter 11 or Chapter 7 filing several years before. That's all the more reason to make certain that the information you get on your credit application as well as through your credit reports contain a thorough background check on the officers, directors and stockholders of the company. If a company's stock is owned 100% by one individual and you are shipping significant amounts to that debtor, doing a thorough background check either through the credit bureaus or through a private investigator may well pay off. While a private investigator may charge anywhere from $500-$5,000 for such a background check, if you are giving a customer net 30 day terms on a $100,000 credit limit or more, then the investment for that background check may be money well spent.
The detectives will go beyond checking what the credit bureaus or credit agencies check out as they often work with local police departments and other sources to make certain that there is no criminal activity by the principals. They also search through such databases as Lexus-Nexus to determine if any officers/ stockholders/principals were ever involved in any illegal action, been sued, etc. Also, remember that a high percentage of lawsuits are settled "out of court" and may not show up on any credit report. A private investigator may be able to find out such matters for you.
14) Is the debtor selling off assets? If so, which ones and why?
While a debtor selling off certain assets may not always be a bad thing. It is alwayssomething to watch for. If a company has decided to concentrate on its core operations or
focus on what made it successful in the first place and it has decided to sell off assets that do not relate to its core business, many times this is a good thing--but not always. Keeping this in perspective, along with the financial condition of the debtor gives you a more complete picture.
Often firms unload certain assets which can be anything from machinery and equipment to plants and operational divisions, to help reduce its debtload. If this is the case, keep your ears and eyes open. The next thing that might happen, if the debtor does not obtain their asking price for the assets they are trying to sell or if they cannot find a buyer--the next step may be filing for bankruptcy protection.
Often, for larger companies, investment bankers or other commercial finance firms or merger and acquisition houses will be hired to either dispose of certain assets or find buyers for them.
Be aware of who these outside brokers are and what their fees are. Feel free to contact them to obtain as much information as possible. Also, become familiar with the websites of the brokerages/investment bankers or finance companies that may be involved in any such asset sales. Surprisingly this often can give you a wealth of information.
By asking the right questions and making use of some of the tips outlined above, you may stay ahead of other creditors when it comes to noticing the red flags that companies throw up prior to their filing for bankruptcy protection.
For additional information on any of your bankrupt accounts contact the U.S. Business Journal and let them research this information for you
This article is furnished by the U.S. Business Journal, P.O. Box 5453, Evanston, Il 60204. The U.S. Business Journal is the oldest Daily E-Newspaper that has been in business 20 years and exclusively reports on financially troubled companies nationwide.