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Beyond the numbers
(posted: 4th May 2010)

Identifying early warning signs of trouble in a prospective borrower: The use of “Management Metrics” can make a crucial difference

By Gerald M. Sherman, David Brown and Eric Sweeney

Over the past several decades, considerable research has been conducted into the causes of business distress and business failure. Many of these studies suggest that most severe business difficulties are rooted in non-financial issues, most particularly the practices and personalities of executive management and ownership. Despite this, albeit with much good reason, the process of considering new loans at both the banking and finance company level puts little focus on assessing the management capabilities of a prospective borrower. This article will present a structured approach for going “beyond the numbers” to identify early warning signs of future financial difficulties by looking at seven management metrics. With consistent and thoughtful use, the metrics being presented should help improve the likelihood for spotting serious management issues before the borrower’s results turn down significantly. Realistic strategies to address early warning signs of trouble, while still encouraging and supporting new business efforts, will also be suggested.

In addition to being supported by academic research, a focus on management just makes good sense. Management makes the decisions that impact capital structure. Management makes the decisions that determine a company’s ability to produce efficiently. Management makes the decisions about what products and services to market and where to market them. Management leads – or doesn’t.

The insights and methods being presented aren’t considered to be an even close to perfect method for identifying early warning signs. Rather, the intention is to provide a simple and realistic approach for lenders and lending managers to pro-actively identify issues of concern about management – at least some of the time. It’s also important to note that the observations and techniques being presented are intended to be applicable for medium and smaller sized borrowers with annual sales volumes of $250 million and under. Regardless, many of the comments will be equally relevant for larger companies.

Today’s typical approach to evaluating new loan requests

Commercial lenders review a prospective borrower’s financial statements and other financially oriented information which would usually include receivable and payable ageings; equipment, real estate and inventory appraisals; financial projections and “business plans” prepared for future periods, etc. In addition, references may be checked, credit reports may be reviewed and some level of industry analysis might be undertaken. Needless to say, this is done to evaluate the current creditworthiness and future prospects of the borrower. Unquestionably, this overall approach is time tested and generally effective. At the same time, it’s important to point out that the ability of a prospective borrower’s management to deliver projected financial results is typically assessed in a cursory manner – if at all. Further, any method used for assessing a management team’s capabilities is often applied inconsistently within the same bank or finance company.

Key limitations in the commercial lending environment

Looking at today’s environment for generating new commercial and industrial loans of acceptable quality, there are several factors that should be acknowledged. First, commercial lenders, particularly those with substantial new business responsibility, are under severe pressure to maintain their productivity. Second, lenders with a focus on new business have to balance the credit worthiness of a prospective borrower with the need to win new business in a highly competitive environment. Third, lenders are experienced in lending practices and finance. For the most part, they haven’t spent significant time managing a business or dealing with the management issues a potentially troubled company may be confronting.

Given these factors, any structured method to enhance a lender’s focus on early warning signs must meet several criteria. First, it has to be simple – simple to understand and simple to use. Second, it has to be time efficient – both lenders and their managers must perceive a return on their investment of time. Third, the effort has to be viewed as an approach to structuring and winning new business, not just an effort to turn down marginal, albeit perhaps still creditworthy loans. Finally, any method adopted must allow senior management to hold lenders accountable for its effective use.

Research focused on poor business performance

The “Z-Score” was developed and validated by Professor Edward Altman of New York University over twenty years ago as a quantitative method for predicting a company’s likelihood for a future bankruptcy. Given that it’s looked at by some lending organizations, it’s important to consider. To calculate the “Z-Score”, the following ratios are utilized:

  • Working Capital/Total Asset
  • Retained Earnings/Total Assets
  • EBITDA/Total Assets
  • Market Value of Equity/Total Liabilities
  • Net Sales/Total Assets

As a purely quantitative approach to the search for early warning signs, the “Z-Score” is looking at the financial results a management team has produced. By focusing on the management of prospective borrowers though, the goal would be to identify early warning signs of trouble before financial results turn down significantly. For example, a family owned business could have a very strong Balance Sheet. At the same time though, its new generation of family management might not have the capabilities the company needs to continue its success.

Another quantitative method that’s utilized from time to time to predict future bankruptcies is the “O-Ratio” which was developed by Professor James Ohlson. The “O-Ratio” is considered to be particularly useful with somewhat smaller companies. Like the “”Z-Score”, it’s calculated using a company’s financial statement data. Accordingly, as with the “Z-Score”, the “O-Ratio” looks at the financial results a management team has produced. Management, once again, is not considered.

Moving beyond quantitative approaches, a great deal of academic research has been published that focuses on the relationships between management and business difficulties. Professor Robert Boyle of the University of Texas published an article in the Journal of Small Business Management titled “Turnaround Strategies for Small Firms”. In that article, he reported several key findings:

  • Business failure correlated with the internal environment of a company more than its external environment.
  • Solutions to internal problems are generally administrative, not strategic.

These findings suggest rather clearly that management is central to business failures.

Robert Lussier, an Associate Professor of management and research methods at Springfield College, published a highly informative article titled “A nonfinancial business success versus failure prediction model”, also in the Journal of Small Business Management. In that article, Professor Lussier reported the results of his study of 216 companies. Using logistic regression techniques, he tested the following 15 factors and their correlation to success or failure:

  • Planning
  • Professional advisors
  • Education
  • Staff
  • Parents owned a business
  • Capital
  • Financial control
  • Industry experience
  • Experience
  • Business timing
  • Economic conditions
  • Age of owner
  • Partners
  • Minority ownership
  • Marketing skills

The four factors most strongly correlated with business failure were planning, professional advisors, education and staff – areas clearly driven by management. This doesn’t suggest than the other factors tested have no importance in predicting failure.

Rather, these findings suggest that factors determined by management have a particularly strong impact.

A number of popular business books have also examined the causes of both business success and business failure. Three particularly notable examples are Tom Peters’ book “In  Search  of  Excellence”,  Jim  Collins’  “Good  to  Great” and  Sydney  Finklestein’s “Why Smart Executives Fail”. The findings presented in each book share many common themes and are largely consistent with the two articles presented above. While each of these books focused on larger public companies, it would appear reasonable to assume that their findings would generally apply to smaller companies as well. In fact, to the extent that smaller companies are often dominated by one or several owner/managers, it could be argued that the impact of senior management in smaller companies is even more significant than with large national and multi-national organizations.

The design and use of “Management Metrics” to identify early warning signs

As discussed previously, any enhanced effort to identify early warning signs of trouble by looking at management must meet several key criteria. First, the process must be effective for lenders equipped with the typical skill sets that can be expected. Second, the process must be time efficient. Third, the process has to be viewed as being supportive of new business efforts. Lastly, the process has to allow senior lending management to establish accountability for its use.

The design of a process meeting these criteria isn’t a simple task and no existing research has been identified that provides clear guidance. Looking at both existing research and experience though, the seven “Management Metrics” detailed below should provide valuable insight into the practices and capabilities of a prospect’s management. The first three metrics look at a company’s management practices in the area of planning and the fourth looks at a company’s emphasis on the training of staff. Both of these are critical areas that Professor Robert Lussier linked to failure in the research previously cited. The last three metrics help assess management’s historic performance against a series of clear criteria.

1.    Has the company prepared annual financial plans for two or more prior years?

This metric will provide the lender with an appreciation of the extent to which a prospect engages in short-term planning.

2.    If an annual financial plan has been prepared, does it include a monthly? projection of the Income Statement, Cash Flow and the Balance Sheet?

This indicates the extent to which the company has invested the time and effort to truly understand its short-term outlook. If these three statements have not been projected on a monthly basis going out for 12 months, it could suggest a less than full appreciation of the need for and benefit of such planning.

3.    Does the company have a written strategic plan for the company going out 24 months or more?

This metric will provide the lender with an appreciation of the extent to which a prospect engages in longer-term planning.

4.    Does the company have a training budget in its financial plan? (assuming it has a financial plan)

This metric help assess the extent to which a prospect is committed to preparing its management and staff to function effectively in the future.

5.    Over the two prior years, has the company been able to perform within 15%, plus or minus, against plan on key Income Statement and Balance Sheet measures.

The key measures to look at would include sales; gross margin; selling, general & administrative expense; interest expense; cash balances, borrowing requirements, account receivable turn, account payable turn, current ratio and debt to worth. If the company has consistently failed to perform within 15% of a number of these measures, a variety of issues could be suggested. These would include an inability to plan effectively and/or an inability to execute against plan.

6.    Has any key ratio in the prospects Income Statement or Balance Sheet more than 20% below industry norms for two or more years?

Has the company demonstrated a history of failing to come within 20% of industry norms on any key Income Statement, Cash Flow and Balance Sheet measures? These key norms would include gross margin; selling, general & administrative expense; interest expense; cash balances, borrowing requirements, account receivable turn, account payable turn, current ratio and debt to worth. Sales per employee can also be a useful measure from time to time.

If the company has consistently failed to come within 20% of industry norm on one or several key measures, a variety of issues could be suggested. These would include an inability to recognize that the company is below industry norm and/or an inability to resolve the problems which have caused the company to fall below those norms.

7.    Has the company experienced dilution which is more than 33% above industry norms for two or more years?

Dilution for the purpose of this metric is defined as:

(Bad debts + credits issued + sales allowances granted (all for a 12 month period))
Sales for the same 12 month period

In many industries, dilution of 5% or less is considered acceptable. When looking at a prospective borrower, however, industry norms should be verified as they do vary. If the prospect has had high dilution, it could suggest a range of issues. If the problem is bad debts, it could be a weak credit and collection process. If the problem is in credits or allowances, it could suggest quality and/or delivery problems.

If any of these problems have gone on for two or more years, it would suggest that management has not been able to identify and/or rectify the issue.

Using the seven management metrics

Unlike the “Z-Score”, these seven metrics don’t provide a definitive measure or answer. Rather, “themes” will invariably appear in the results. These “themes” will help lenders and lending managers form an assessment of the overall capabilities and performance of a prospect’s management. When the responses are consistently positive, a lender and senior lending management should have an increased level of confidence in a prospect’s management.

When the responses are mixed or generally negative, further effort is called for. The level of effort and its exact nature has to be determined by the circumstances of the prospect. For example, if the company has experienced high dilution for several years, the lender needs to understand both why dilution has been high and what’s being done to improve the situation. By doing so, the lender can learn more about the prospect from both the content and the nature of their response. If, for example, the prospect rapidly concedes that high credits have been an issue and outlines a program that’s been put in place to reduce them, the lender might be able to upgrade their overall assessment somewhat. On the other hand, if the prospect doesn’t fully appreciate the problem or doesn’t have a plan of remediation, the overall assessment of management would likely be lowered even further.

Faced with results that create significant concerns, the lender has a range of options. One choice is to do nothing. Assuming that the prospect is otherwise creditworthy, the lender could choose to approve the loan request but increase their level of internal oversight. Further, the lender could choose to stay in more regular contact with the borrower. Given the highly competitive lending environment, this approach would often be the right one.

Alternatively, the lender could ask for more information such as a 12 month (or longer term) plan, a more detailed analysis of projected sales, information on historic sales, etc. Another relatively mild response would be to ask for enhanced reporting from the borrower. In more difficult situations, requests for additional collateral, additional guarantees or a change in loan structure are always possibilities.

On a worst case basis, if management metrics lead the lender to a point where the loan becomes undesirable, the request can simply be declined.

Final comments

There have been numerous instances of loans “going bad” within weeks or months of their approval. Putting aside these relatively unusual situations, the effort to go “beyond the numbers” by using management metrics has the potential to help lenders book and manage loans efficiently and effectively. Being realistic, academic research to support and refine the use of management metrics would likely be of very important. Without such validation, it’s likely that the use of management metrics as part of the due diligence process would become accepted on a limited basis, if at all. Regardless, it’s important to conclude by also recognizing that the on-going judgments of every lender and their managers will always remain crucial to evaluating, structuring and booking good loans.

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