|| Is Your Business in Distress? Red Flags || BR#2

By Mark Taylor, Khanya Mathambo, Gordon Bell and Sandra Beswick

15 August 2024

You’re director of a struggling business – what red flags should you watch out for?

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Why Red Flags?

A red flag is a ‘rule of thumb’ that warns you that things are not as they seem.? These heuristics are unwelcome surprises that alert you to dig deeper.? Directors (including non-executives) and senior management ignore these red flags at their peril because they risk trading in insolvent circumstances and subsequently being held personally liable by creditors and financiers who suffer loss.

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Governance is like toilet paper…

It doesn’t seem very interesting but, without it, things can get messy.? Poor governance is almost always present in distressed businesses and is a topic on its own.? If governance is good, it is far less likely that there will be any red flags.? Watch out for our future article on governance.

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Hope is a Great Attitude, but it is not a Strategy

Hope is also not a good defence in court when your business is adjudged to have traded in insolvent circumstances. ?Often directors and management hope to trade out of difficulties based on the ‘next big deal’ and don’t change the way they operate. ?When management is emotionally invested, it’s far more difficult to make rational and logical decisions.

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Every business and industry is different, so the red flags can differ, but here are some key red flags we think are important.

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Cash is King

An absence of regularly monthly reporting on performance against a board-approved budget, including a balance sheet and cash flow.? It’s possible that the balance sheet is only updated in detail less regularly, but understanding the working capital cycle and being able to reconcile the balance sheet and income statement are crucial.? If reports and monthly performance meetings with management start to get delayed, are sloppy, or even avoided, this is a red flag.? To be clear, if there is no easy-to-understand cash flow report in your board pack, this is not a red flag, it’s probably already too late.

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Revenue is Vanity, Profit is Sanity, and Cash is Reality

If this well-trodden aphorism is new to you, go to the naughty corner of the board room.? Look out for changes by management in their performance measures (especially for their incentives).? If it was cash flow, and it has now become a profitability or revenue measure, get out of the boardroom and into the CFO’s office for a heart-to-heart.? It’s possible there are good reasons for this (yeah, we all know that in tech start-ups winning subscribers or users is a land grab, and first to market wins, blah, blah, blah, but it is only one of several useful measures).

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It's the little things…

Watch out for the following in your financial reporting: unplanned regular cash flow problems and sudden applications for extra debt facilities, the cash conversion cycle, especially creditor days[MT1]? being extended without a compelling explanation, increased debtors days, growing or slow-moving stock, unusual asset re-valuations, weakening margins (now is the time for a request to the CFO that they put out a board paper on the company products’ unit economics), and a deteriorating debt-to-equity ratio.

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What are customer reviews like?? Is cost-cutting or under-investment in new products or services becoming an own goal?? Try checking the online presence and comments to corroborate what the teams is saying, or to alert them that you’ve noticed changes.

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What is the business’ litigation record like (whether impending or settled)?? This should be reported to the board irrespective of how big or small the matter appears.

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And the big things…

It’s hard to measure staff morale but, if there are senior resignations (particularly the CFO), consider conducting an exit interview with the departing exec.? It may be that this needs to be a simple informal coffee, but it’s a great opportunity to see what’s really going on under the hood.

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What risks does the board focus on?? This is part science and part art.? Call for the risk register and consider how well probability and impact has been scored.? Ask the senior executives what keeps them up at night.? Risk mitigation in a VUCA world is also an art, the domain of expert readers of tea leaves, from futures thinkers to commodities traders, seeking to understand the non-linear and complex inter-connectedness of modern risk events.

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SARS is the Piggybank of Distressed Businesses

Unlike other creditors, SARS does not chase your company frantically for payment on a monthly basis and it’s easy to be disarmed by this.? When creditors are prioritised in a crisis, SARS will almost always draw the short straw even though taxes like VAT are held on behalf of SARS and are definitely not the company’s property.? Because SARS is an easy target, the practice of deferring payments to SARS in the hope that cash flow will improve next month is a secret code from the CFO that the finances are in a mess.? Therefore, a red flag is whether all SARS payments are up to date.

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Without wanting to sound preachy, there is a deeper ethical problem when PAYE (which includes UIF) is not paid.? You may dislike paying SARS but, if PAYE is not up to date, this is akin to stealing from your staff because they will have no unemployment benefits when the business goes insolvent and may have to cough up funds to pay SARS when their annual assessments are done. ?Union representatives, take note of this red flag!

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Investor-Readiness Health Check

If you are a director and unsure about your prospects to raise capital, contact your lawyer, accountant, or get Cala Capital Africa to conduct its “Investor-Readiness Health Check” for your business.

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Thanks to Sandra Beswick of Fluence Capital for contributing to this article.? Sandra is a highly experienced business rescue practitioner and former banker and recently provided wisdom to Cala Capital Africa with a business rescue.

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Mark Taylor is the CEO of Cala Capital Africa , a leading capital matcher which connects qualified global and domestic investors to vetted African businesses seeking $10m to $100m+ in growth capital. Mark is also a senior business rescue practitioner.