Magazine article Business Credit

Red Flags for Red Ink: Warning Signs of a Troubled Business

Magazine article Business Credit

Red Flags for Red Ink: Warning Signs of a Troubled Business

Article excerpt

L.A. Gear became one of the nation's most successful apparel retailers in the 1980s, rocketing to $900 million in annual sales almost overnight. Yet, as quickly as the company dazzled investors, it left them in distress. Earnings began to fall sharply in 1990. Then, the SEC accused the company of fraudulently misstating its revenues. L.A. Gear's market valuation, which had reached a high of $1.4 billion, fell to just $250 million by 1992 when restructuring by a new management team began to turn the situation around.

Similarly, at Royal Appliance Manufacturing Company--home of the "Dirt Devil"--sales multiplied tenfold over four years, reaching $270 million in 1991. Its stock went from a split-adjusted $7.50 at its initial public offering in August 1991, to a high of $31 in February 1992. Despite rapid sales growth, in July 1992 the stock plummeted to less than $9 a share, losing over $300 million in market value in a few weeks due to runaway advertising and other expenses which caused quarterly earnings to drop 78 percent lower than the previous year.

Unfortunately, so-called surprises are not all that uncommon. Sometimes the stories involve apparent mismanagement, like those mentioned above. Other times, there is mismanagement by fraud--ZZZZ Best, Crazy Eddie, and College Bound, not to mention the S&L crisis.

Few such scenarios make big headlines. Most only cause quiet headaches for directors, lenders, vendors, and investors because the circumstances are less dramatic or the company involved is smaller, privately held, or a subsidiary.

Not just small investors and creditors are swindled when the bottom falls out of a company. There are many banks, pension and mutual funds, insurance companies, vendors, customers, and others who are taken in--professionals who generally know better. Furthermore, these scenarios take place in broad daylight, even with public companies who are under the eye of internal and outside auditors, lawyers and consultants, a board of directors, securities analysts, stock exchange officials, and government and industry watchdogs.

Therefore, most often those who are "surprised" have actually been fooling themselves. Such surprises are almost always preceded by months and even years of numerous visible fractures in the foundation of a business.

Early signs of trouble, of course, are deliberately ignored by shoot-from-the-hip investors, with predictable results. However, most investors are fairly dispassionate. They get caught short by relying on superficial or misleading information or short-cut numbers formulas and end up badly misreading a company's situation.

Admittedly, interpreting business information can be tricky because of the subtlety and contradictions of the information. Nevertheless, a good checklist that most people will find useful even without formal education in accounting and business can be drawn from experience.

What is a red flag in one business, of course, might be a sign of strength in another. Therefore, relying on any single factor in isolation can lead to false alarms or a false sense of security. On the other hand, when worrisome conditions exist for long, or in patterns, explanations should be sought.

Those doing business or investing in public companies can find most necessary information by reading annual reports, 10-Ks, 10-Qs, proxy statements, analyst reviews, and company literature.

For privately owned businesses, generally only the financials and company literature are available to creditors and investors. Credit history information can usually be obtained from reporting agencies such as NACM. However, private companies may use unconventional accounting practices and have reduced scrutiny from outside auditors, if they are audited at all. Although that all might be quite "normal" given the size and circumstance of the business, it does not change the rule: The absence of controls, even for understandable reasons, should prompt caution and more investigation. …

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