Oftentimes companies’ reported figures point to a low credit risk, while the truth is completely the opposite. One is at risk of making a wrong decision, for example, to extend and / or increase a credit limit to a company with a high risk of default. The initial reaction to a “sudden” default for many is shock and disbelief. However, more often than not, the early warning signs (EWS) were already there.
Let’s have a look at the one example of a default which was not supposed to happen, at least according to the reported figures.
The manufacturer’s most recent figures were as follows:
The figures above look reassuring.
So, what went wrong?
In this specific case, there were several EWS visible in the company’s financial statements:
* There were numerous adjustments of key figures needed to set the proper analytical base, such as (i) debt adjustment for excess debt towards suppliers, (ii) adjustments of EBITDA, NOCF and Capex for capitalized development costs, (iii) debt and EBITDA adjustment for operating leases, and (iv) EU grants, asset revaluation, and loans to owners treatment within cash flow.
The EWS above certainly provide a different angle on the company’s performance, but the company still had enough liquidity, generally low leverage, and solid margins.
What were the main reasons behind the default?
Firstly – size matters. Company with sales of EUR 6m can hardly be a market leader and have high bargaining power. While the company managed to extend payment to suppliers beyond reasonable level for years, this has always been a latent risk. Suppliers could always change their policy and demand payments in line with legal requirements, and thus bring the company into difficulties. Weak competitive position and issues with the working capital management severely impacted the company’s business risk profile.
Secondly – aggressive financial policy can have a decisive effect on the risk assessment. Favouring shareholders over creditors (including suppliers) always signals high financial risk, especially the excessive risk taken in this case. Such financial policy can make all financial ratios redundant. The worst part is that this was visible in the company’s financial statements, but it was necessary to dig deeper. This has limited company’s financial risk profile to “very high risk” in a way that even the nominally strong liquidity ratios were of a lesser importance when the financial policy is estimated as aggressive.
How to spot this kind of companies?
1) It is crucial to dig deeper into the financial statements. Oftentimes it is necessary to perform several adjustments to have meaningful figures. Besides that, the form of the cash flow statement has to be adapted to the analytical process.
2) Everybody should do his / her own analysis and not blindly trust the providers of financial information. Such providers do not dig deep and challenge figures. In this specific case, 1-year PD, as suggested by the financial information provider, was 0,12%, while CreditAnalyst.eu rating (“C”, one notch above default) estimated 1-year PD at above 20%, while 5-year PD amounted to approx. 50%.
No statistical model can replace own deep analysis. This is the only way to make sure the losses of money and reputation are minimized.
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