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Financial Adviser: Is my business in financial trouble?

What's the number one tell-tale sign? Rising debt-to-asset ratio.
By Henry Ong |

Q: My business has not been doing well lately. Though I am hopeful that it will recover soon, I am anxious that I have to do something now to avoid any financial problems later. How do I know if my business is heading into financial troubles? Any tips on how to prevent this? – Basilio, by email

 

 

A: It is every entrepreneur's nightmare to see their business run out of money one day and be unable to settle its financial obligations to creditors, forcing the company to fold up. Very often, the symptoms of imminent financial disaster are ignored until the big day arrives. Here are tell-tale signs that your business could be heading into serious financial disaster:

 

 

1. Rising debt-to-asset ratio. 

It is normal for a business to purchase merchandise on credit or expand the business by borrowing money from the bank, but if the total payables and debt as percentage of asset is increasing over time, then it is a sign that the business is becoming highly risky.

 

A ratio of more than 60% is considered a sign of potential trouble ahead if not managed properly. A higher debt-to-asset ratio would mean that the business would have more debt to service, thus greater drain on cash flow and profitability.

 

 

2. Slowing inventory turnover. 

A slowdown in inventory movement means either sales growth is weak, or inventory is expanding too rapidly relative to normal sales level. Whichever scenario it is, it only means that the business may not be managing its cash prudently, as too much cash is tied up to slow moving inventory. Holding inventory too long in the warehouse indicates potential liquidity problems for the business.

 

 

3. Unpredictable and erratic sales. 

When sales become irregular, this means cash collections become irregular, too. With cash inflows becoming highly volatile, the business may not be able to sufficiently finance all its disbursements and payment commitments. This may result to regular bank borrowing to fund its working capital needs in order to sustain its operating expenses.

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4. Weakening pricing power and deteriorating gross margins.

This happens when the market is getting highly competitive and the business is pressured to lower its selling prices in order to keep up with the monthly sales quota. A lower selling price that does not result to a higher sales amount means lower total gross margin, which could hurt the business by not contributing enough cash flows to cover monthly operating expenses.

 

 

5. Slowing cash collection.

An inefficient cash collection system very often results to longer collection period, which means lower cash flows. Tight liquidity situation may force the business to bridge finance its working capital shortfalls by borrowing outside at high interest costs. If this kind of situation continues for some time, the business faces higher risks of potential cash flow problems in the future.

 

 

6. Problematic cash flows.

When checks issued are bouncing and payment can not be made in due time, the business may be struggling with cash flow difficulties. Lack of monitoring and poor discipline of forecasting to properly match sources and uses of cash are the causes of this problem. Failing to pay a supplier or a bank a large amount on due date can lead to closure of the business.

 

 

7. High employee turnover.

When employee retention is poor, it indicates that people in the business lack belief in the company or in the management. And without the right people to run the business, leadership will suffer that would ultimately hurt the company.

 

 

Addressing the problems

All the above red flags indicate underlying problem in the business that need to be addressed. Here are some tips on how to address the issues properly:

 

1. Evaluate your product or service if it is still competitive in the market, and if its pricing still gives you satisfactory level of margin to sustain your business.

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2. Change your product or service completely if market demand has changed because of technological changes and new competition.

 

3. Monitor your cash flows regularly to keep you informed of the true financial condition of the business. Your decision on money matters will be easier if you know what you have in the bank.

 

4. Implement good accounting practice by having all transactions recorded properly for review and assessment of the business' financial performance.

 

5. Improve your people management skills and recruitment practices to hire the right people for your company.

 

6. Practice financial planning for the business, for yourself, and for your key employees to protect you from unexpected event such as illness, unfavorable business incidents, or bankruptcy of a major client that could not pay the business and others.

 

*****

Henry Ong, CMC, is president of Business Sense Financial Advisors. You can follow him at @henryong888 or email hong[at]businesssense.com.ph.

 

Photos from Thinkstock and Shutterstock

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