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Warning Signs of a Company in Trouble

When considering an acquisition of, investment in, or employment with a company it is best for your peace of mind, as well as, financially to be aware of indications that the company’s true picture may not be what management would lead you to believe.

Warning Signs of a Company in Trouble

The surest sign that something is amiss is a frustrated stakeholder – be it the owner, investors, or lenders. What are their concerns? Have there been repetitive problems with the company? Does management not seem to have the right skill set to handle the most pressing issues? Does management spend too much time assessing blame and not a lot of time accurately identifying the company’s problems and devising solutions?

Where to Start

It is best to first take a look at the company’s financials. Start with the balance sheet. Are they building inventory and not able to sell it? Do they have a negative cash position? Have they maxed out their borrowing base? Also be sure that the balance sheet reflects the true state of affairs. For example, has the company written a check which it has yet to mail despite debiting its accounts payable account?

Take a look at the income statement, preferably one with monthly performance over the last 12 months. Group the items into three categories: sales, variable costs including direct sales costs, and fixed costs. What trends do you see in those categories? Perform a breakeven analysis. What is their contribution margin? Is it declining? What about EBIT? Is the company able to service its debt?

It can be helpful to simplify a company’s financial statements, combining similar items in order to move out of the detail and focus on the company’s overall performance and financial position.

The greatest mistake is not necessarily investing in a troubled company, but rather misdiagnosing the company’s problem(s).

Checklist

Here are some items to consider when performing diligence on a company:

Cash shortfall – does the company seem to be constantly in a cash crunch?

Physical deterioration of facilities – signs of inability to maintain facilities due to lack of proper planning and ability to re-invest.

Poor Accounting Systems – accounting records and reporting are delinquent. Often the company does not know if they are making money or losing money.

High concentration of leased assets – inability to secure traditional financing

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Warning Signs of a Company in Trouble
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Warning Signs of a Company in Trouble

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Margin Versus Mark-Up

Communicating simple accounting and finance measures to colleagues can be a challenge. Take, for example, gross profit margin percentage and mark-up percentage or simply margin versus mark-up. To non-finance professionals, these two measures may seem to be interchangeable. But they’re not. Mark-up percentage is generally a marketing measure used in pricing decisions made by marketing professionals. Financial professionals use gross profit margin percentage as a measure when reviewing a company’s income statement.

Margin Versus Mark-Up

Calculate mark-up percentage by dividing a product’s unit cost by the gross profit. You get gross profit by subtracting a product’s unit cost from its sales price and assuming that cost reflects COGS on a per unit basis. Gross profit margin percentage is when you divide the amount of gross profit by sales on the income statement. Compute it on a per unit basis. So the primary difference between the two percentage calculations lies in whether gross profit is divided by cost or by sales. Differences may also exist due to the product costing method you use to determine the cost per unit sold.

It may be helpful to explain to non-finance managers the impact of a prospective price increase in terms of gross profit margin percentage. Then leave out the mark-up measure altogether.

Margin Versus Mark-Up

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