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Is This Business D.O.A. Analyzing the key factors that drive small business into distress

As turnaround/restructuring professionals, we are brought into distressed situations because of our knowledge of the legal framework, experience in similar situations, management and leadership qualities, and ability to rapidly assess and address the underlying causes of crisis (underperformance).

Parties-at-interest expect us to efficiently determine the depth of the problem and the likelihood of each outcome, whether (i) a successful operational turnaround, (ii) sale of the enterprise, (iii) forgiveness or exchange of debt, (iv) Chapter 11 filing for purposes of rehabilitation, or (v) liquidation [through various mechanisms].This early evaluation is often called a “feasibility analysis.”

In the opening weeks of an engagement however, we not only work through a series of financial exercises to best understand the company’s condition and opportunities for profit enhancement, but also survey the standing, awareness and attitudes of important constituencies. Absorbing this knowledge regarding key relationships helps us gauge the various degrees of support and trust, which ultimately influences our assessment of the viability of the enterprise.

Time is the Unforgiving Driver

…and each course of action has its own time requirement. This makes an early assessment of cash flow the critical thermometer by which the degree-of-distress of the company is measured.

Cash flow models are carefully and honestly built (or rebuilt), and are typically a 13-week rolling cash flow supported by a 12-month monthly cash flow.From this, we determine the number of weeks of cash still available to operate the business.The survival time can vary from days (can’t meet payroll this Friday) to 52 weeks or longer; for many distressed situations, cash reserves are forecast to last from 3 to 30 weeks.

A short cash lifeline has enormous power: it can, among other things, force liquidation, cause management to abandon plans to seek out a strategic buyer, soften or repel a secured lender(s), compel a fast-track §363 sale, and demand severe and immediate cost cutbacks/personnel reduction.

Secured Lender as the Driver

In many distressed situations, the borrower is in covenant default, has exhausted its line of credit and available assets, and is under lender pressure. Lenders are highly focused on reliable financial statements and forecasts, which are both rare commodities in the world of distress. So rare in fact, that frequently the credibility of the borrower has eroded.

To this often emotionally charged situation, we bring not only added skills and resources, but impartiality, integrity and the restoration of credibility…all of which are essential to developing cooperation from the lender.

Driving the Stake…holders

Most smaller businesses are owner-managed and privately held. They typically lack any Board of Directors; if a board is present, it’s filled with friends and “yes-men” for the owner/manager.

Management (ownership) has usually lost credibility and stature with the lender, and surprisingly often, credibility and stature with its principal constituencies, such as employees, unions, vendors, customers and shareholders.

The beauty of our forgiving American process is that we are compelled to leave the floundering business largely in the control of those very people who have (i) lost credibility, (ii) squandered their equity cushion and (iii) unequivocally proven their ability to lead the business into crisis… and then expect them to (iv) work in the best interest of creditors and (v) restore the business to the full bloom of health.

Trade Creditors in the Driver’s Seat In the typical situation, trade credit has been stretched, sometime unmercifully.In the later stages of distress, vendors have tightened credit and/or terms and, in very late stages, moved purchasing to a COD or CIA basis. We carefully review days of payables on a historic basis to compare to the present, deteriorated state.

We are concerned with the level of vendor awareness, which is an empirical assessment of the degree to which the distress within the company has become known to suppliers—alternative suppliers may be difficult to obtain. A similar measure of awareness at the customer and employee level is also of importance. In smaller businesses in particular, owners have often gone to great lengths to insulate the company’s problems from employees… leaving them in blissful ignorance as the company slides inexorably toward oblivion.

Where payables have not been stretched, we are often engaged in methodical programs to carefully extend payables to provide added liquidity and survival time.

Management Integrity Driven into the Ground

In addition to the impaired credibility of owner/managers, we often find “burnout” among the management ranks.Most prone are CFOs, then CEOs, who suffer the brunt of lender and vendor pressure. Those who avoid burnout often accomplish this through “denial,” a refusal to react to, or even recognize, the depth-of-distress in which the business is mired. Symptoms of this strange, amazing condition range from optimism and wishful thinking to something like deer staring transfixed in the headlights.

Also, in owner/operator businesses, we have come to expect a level of self-dealing regarding the “perks” of ownership, which can include cars, company payments for personal needs, incompetent relatives in meaningful roles, overloaded and dead-wood payrolls or even cash diversion. On occasion, these perks spill over into fraud and embezzlement, which is often explained as “it began innocently as a short-term remedy” …that became addictive.


Author: Robert A. Morris

Robert A. Morris, Managing Director for Morris-Anderson and Associates, has extensive expertise in turnaround consulting, systems development, business appraisal and acquisition strategy, with more than 25 years of experience in analytic, financial and line operating management. He can be reached at (847) 945-0767 or rmorris-morris-anderson.com.

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