Gauteng Business News

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BUSINESS: Detecting ‘red FlagsÂ’ Early Can Help Avoid Severe


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A financially distressed company can be nursed back to health if the warning signals and other ‘red flags’ are monitored and picked up early enough in the process, says professional services firm PwC. “A company can be turned around by acting timeously on early warning signals and thereby resolving underperformance,” says Stefan Smyth, the National Leader for Business Recovery Services, PwC South Africa.

However, Smyth says that slow or ineffective response by directors and executives can lead to rapidly spiralling underperformance in companies, which ultimately leads to the most severe financial distress and even liquidation in certain instances. “Time is of the essence if a company is in financial distress. The longer management stalls in taking action, the more dire the consequences for the company concerned.”

If interventions have been unsuccessful or applied too late then Business Rescue proceedings under Chapter 6 of the Companies Act, 2008 offers an alternative option to liquidation. Severely financially distressed companies who can demonstrate future viability can then use Chapter 6 as a vehicle to stabilise and restructure. The new law aims to assist companies in reorganising and restructuring their business affairs.

However. even here timing is crucial and companies are well advised to realise that the trigger for rescue (6 months of liquidity/solvency) is there to ensure that there is sufficient cash/assets remaining to effect a rescue – all too often Business Rescue is filed when the company has exhausted its cash and reserves and cannot afford either the costs associated with Business Rescue or to fund working capital.

Companies in financial distress often wait too long to address their problems as they are slow in responding to ‘red flags’ and other critical warning signs. “In such cases, the options for turnaround are few and far between. The company’s relationships with key stakeholders may also have been damaged resulting in a loss of faith and correspondingly limited access to extra capital from funders or shareholders to support a turnaround. The end result is dire for the economy, directors, employees, lenders, customers, suppliers and shareholders alike with economic and enterprise value being diminished for all.”

At some point in any companyÂ’s lifecycle, it can expect that financial pressures will be encountered for a variety of reasons, both foreseen and unforeseen, he says. Management needs to detect or monitor the early warning signals of such financial distress to avert disaster.

“The earlier that management takes steps to turnaround a business, the faster the recovery and the lower the risk for the organisation. The length of the recovery period and costs associated will ultimately be reduced through the speed and effectiveness of interventions undertaken by management.” However, the longer management takes steps to turnaround a business, the recovery options tend to become limited in the rescue process, he explains.

Furthermore, the larger or more complex the pool of stakeholders who are involved in the business, the more complex business recovery tends to become, given the often subjective and polarised views. “Turnaround plans require agility and boldness in their approach on the part of management and often the hiring of a turnaround specialist on an interim basis brings both the requisite experience of what works and the pace of change required. On the whole multiple, concurrent strategies tend to work best.”

Smyth says it is not difficult for management to determine when a company is in some kind of financial distress but all too often the time taken to identify, accept and act on the indicators can mean that the company has deteriorated to the point of illiquidity and/or insolvency. At this point in time, the directors of the company may become personally liable for the debts of the company and can even be sued in their own capacity by creditors, under the far reaching provisions of the Companies Act, 2008.

Smyth says that directors and management need to learn to spot commercial signs of demise. “New indicators and monitoring processes are required. Management needs to regularly and proactively assess and benchmark the business.”
Management needs to monitor and assess the key risk indicators of the business, which includes both financial and non-financial indicators. “Often the financial indicators are too late as a warning sign,” he says.

The warning signs to watch out for include: the loss of key customers; low staff morale/labour unrest; loss of competitive advantage/margin erosion; outdated and unattractive products; increasing and mounting tensions between the company and stakeholders; a failure on the part of management to meet deadlines; and an inability on the part of the management to articulate strategy and to prioritise business objectives. Other ‘red flags’ include regular changes in company policy; superficial forecasting of revenue or cash flow; bank covenant breaches and excessively delayed creditor payments; downgrading of an organisation; poor governance/frequent and excessive changes in the board and senior management; and reliance on once off transactions.

“However, many of these ‘red flags are symptoms of a financial illness – directors need to identify and tackle the root causes, not the symptoms of the sickness,” says Smyth. Directors also need to continuously appraise the business model of the company, particularly its commercial ‘footprint’, including the risk and concentration of both the supply chain and customers. It is easy in well established businesses to assume that the model hasn’t changed and that what worked in the past to correct trading pressures will work now.

It is likely that both the business model and the trading environment are so different now that new tactics and strategies will be required. The long and unpredictable downturn adds an additional layer of complexity to effecting a successful turnaround.

He recommends that any companies in financial distress who are contemplating Business Rescue seek advice from business rescue experts before considering passing a resolution to enter Chapter 6. “The complexity and consequences of this new legislation is high and far-reaching.”

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