How to Deal with the Five Stages of Business Distress

This article first appeared in CFO.com.

No matter how grim things become, it’s important to face each level of distress as soon as it arises and with full transparency.

Economic headwinds are building on the horizon — from increasing interest rates to rising labor costs and virtual full employment. From a slowing global economy to the continuing trade dispute with China. From a slowing housing market to softening capital spending.

If your business is impacted by some of these headwinds, it’s best to face the situation early and with full transparency. For companies that do so, decisions to take on additional risk to be transformative, or to effectuate a turnaround, tend to be well-received and supported by boards, lenders, and other key stakeholders.

This article discusses five stages of business distress and the challenges they present for company management.

Stage 1: Early Warning Signs

Early warning signs of business distress are often written off as insignificant, with an attitude of “this too will pass.” But in many cases, not only should these signs be taken seriously, they can also present an opportunity to transform the business.

Typical early indicators of distress include liquidity issues, overdrafts, out-of-formula borrowings, and unscheduled stretches in payables. Other, more operational-type signs include excessive/unplanned overtime, expedited or missed shipments, loss of a key customer, increased employee turnover, and taking shortcuts on the manufacturing floor that migrate into downstream quality issues.

Perhaps there’s a noticeable gap in bench strength, unprofitable products, underpriced new products and services, or a vendor driving material cost increases.

Whatever the cause(s) may be, the issues must be addressed before the business encounters even more extreme levels of distress. This is the time, while in full control of the business, to reassess strategic positions and business plans, including the capital structure. At such a time, stakeholders are much more likely to support leadership and the proposed actions to preserve and drive value.

Stage 2: Covenant Defaults/Forbearance

Here the level of business distress has grown to the point that debt covenants have been tripped and the company’s secured lender is now looking deeper under the hood. Perhaps the lender has gone as far as issuing a reservation of rights letter or forbearance agreement.

Typically, when EBITDA, cash flow, and fixed-charge covenants are tripped, the underlying causes are deeper than surface-level. The business is entering into crisis management territory, and leadership should begin to focus on preservation of cash and enterprise value.