Financial statements are essential – but are received after (sometimes long after) the performance being reported has occurred.
By the time a borrower’s statements show financial stress, the underlying issues have often been building and happening for months. Revenue declines, margin compression, and covenant pressure typically appear after operational and behavioral cracks have already formed.
For lenders, relying solely on periodic financial reporting can mean reacting late rather than managing risk early. The most effective early warning systems extend beyond the income statement and balance sheet and into real-time operational, behavioral, and people-level signals.
This post outlines several near-term indicators of distress that are often visible well before they show up in financial statements – and why lenders should pay close attention.
Near-Term Signals That Deserve Scrutiny
While not explicitlyprovided to a Lender by a borrower with standard reporting, several adjacent indicators may be a signal of ongoing or upcoming financial stress:
Customers and Suppliers:
- Decline in amounts owing or lengthening in time to pay invoices from a major Customer. May indicate change inthe Customer relationship, possibly planning on ending purchases from Borrower.
- Static level of amounts owing and aging out of amounts owed to major suppliers. May indicate suppliersare no longer willing to extend payment terms, ship,and/or looking to stabilize or reduce exposureto the Borrower
- New suppliers of important material. May indicate that existing vendors no longer willing to supply borrower due to payment issues.
Borrowing patterns
- Frequent draws and repayments that signal liquidity management rather than growth
- Increased revolver usage without corresponding revenue growth
Inventory Composition and Delivery
- Growth in specific classes or items in inventory. May indicate a change in aCustomer’s purchasing intentions going forward.
- Decline in amount or days on hand of key inventory items. May indicate suppliers are restricting credit terms of the Borrower. This is likely to result in decline in operating efficiency.
- Increase in freight costs particularly expedited freight. May indicate that materials are not coming in time to meet timely processing or shipping which could reflect liquidity or operational issues.
Staffing changes Behavior:
Some of the most telling warning signs can be exhibited by Borrowers leadership and staff and are among the most overlooked and easiest to see.
- Executive management disengagement from day-to-day operations
- Departure of next level leadership including controllers, or operations leaders. Be particularly aware if best salespeople leave.
- Interim appointments for permanent roles
- Increased use of temps
- Regular turnover of accounts payable clerks or receptionists. These folks are typically the first line of contactwith unhappy suppliers
What This Means for Lenders
Early warning signs are most useful when they spur action, not just awareness.
For lenders, this means:
- Expanding monitoring beyond periodic financial packages
- Asking operational and personnel-focused questions, not just financial ones
- Tracking trends in behavior as closely as trends in numbers
- In person visits to the Borrower to look for or follow up on early warning signs
It also means engaging professionals that have experience dealing with Company’s experiencing stress and more importantly prepared to take action to address the situation. Harney Partners can play a critical role in diagnosing the underlying causesdriving underperformance and taking action to mitigate and manage these. From understanding and monitoring liquidity,working with suppliers and customers, implementing structural changesand clearly communicating circumstances and solutions to all key stakeholders,HMP can provide the leadership necessary to guide a troubled borrower through challenges.
Conclusion
Financial statements remain a critical foundation for managing creditriskandloan security – but they should not be the sole source of defense. A Company headed for distress willtypically exhibit signs that don’t necessarily show up in these reports
When a Borrower is headed down the path of distress, time is rarely an ally. And the longer it takes to understand and address the underlying issues, the faster a true crisis will happen and with fewer options to deal with it.
Contact Harney to discuss how to look for these or other signs of potential upcoming distress and how to respond in a timely manner. Early action is a benefit toboth you and your borrower
