Most adults know when they're sick enough to call their doctor. Not so with the illness of a business.
Many corporate stewards, even the savviest of CEOs, misdiagnose or ignore serious problems until it is too late. Instead of being able to fix the problem, the only solution is bankruptcy and liquidation.
It doesn't have to be that way. Signs of serious corporate distress can be detected and treated long before they become terminal. As with human illness, early detection and treatment are critical.
Here are some key warning signs:
Over-leveraged capital structures--This is where the ratio of debt to equity and/or debt to earnings before interest, tax, depreciation and amortization is becoming too high or is already too high. This reduces financial flexibility and can result in the company defaulting on its loan agreements. The "safe" level of debt varies with industries and with each company.
Over reliance on short-term capital--A company that has too much reliance on short-term capital runs the risk of a major liquidity crunch if it is unable to roll its short-term debt over. Will your bank roll your debt over if you have a bad quarter? Two bad quarters?
Mismatch in the duration of assets and related finance capital--This would be the equivalent of putting your home mortgage on a credit card. You don't want to be forced to sell a long-term asset/investment to alleviate short-term credit pressure. Finance long-term investments with capital or debt that allows cash in-flows and cash requirements to be matched.
Top-line (revenue) vs. cash flow orientation--When a company is focused on growing sales, it sometimes ignores the amount of capital invested. Using capital in an unproductive manner reduces share price, especially in capital-intensive businesses. Adequate returns have to be provided to shareholders or the equity markets will be foreclosed to a company. An inability to finance growth with internally generated or externally generated equity can lead to extensive debt levels and financial trouble.