Looking both ways before we hit the gas

RMA Journal, The, April, 2004 by Frederick A. Rice

This article looks at some of the red flags that we have seen during the past recession, which resulted in getting the lender into trouble. Nineteen problems are identified as company issues, staffing and employment issues, the customer, and product and service issues.

The economy certainly seems to be on the mend. With the exception of the "jobless recovery" concern, other signs indicate improved economic indicators across the board.

This is an appropriate point to pause and ask: What lessons have we learned? History, as always, is a great teacher for all sorts of situations and events. Historians, statisticians, and economists draw conclusions from the past that are expected to be useful in the future. This past recession is no different.

When I was department head for workouts at a bank during the mid-1980s, my boss was the senior lending officer, a man in his early seventies who had previously been a bank examiner. I was observing all the new business activity and wondered how it was possible that more credits were not going sour. My boss taught me one very important lesson with his comment, "Just wait, I have seen this before and we don't seem to learn from the past!" He basically guaranteed to me that I would soon be inundated with problem loans. He was correct.

Most professionals dealing in corporate renewal or turnaround situations know there are certain operational elements that can be harbingers of disaster. Everyone will agree that it's essential to detect problems early on, while there still are resources available to fix them. Bottom line, though, is that questionable aspects leading to financial problems must be clarified before reaching the crisis stage.

Once a company has found trouble, it can be hard to fully understand how much trouble it's in and to identify what to attack first. As we have seen from the recent recession, and as can be observed from the results of turnaround activities, by then it is often too late!

Those seemingly small, unimportant operational problems are less easily identified and are the ones that can wreak havoc if not corrected early on. It's important not only to uncover these problems but also to understand them completely. While it's popular to have a Top 10 list, there really are 19 things for bankers to focus on when determining a risk profile. These items can be divided into company issues, staffing and employment issues, the customer, and product and service issues.

Company Issues

Management denial. This early-warning signal is almost impossible to detect, since the detector is most often the one in denial. Furthermore, entrepreneurs are optimists, so they tend to focus on the bright side. They also tend to be do-it-yourselfers.

So who leads the manager/ owner to a more realistic view? Assistance in overcoming management denial could be provided by the company's attorney, banker, or CPA, a friend, or even a spouse. By learning to ask questions and really study the answers and reading between the lines, the banker can be more attuned to management.

Market/industry change. Who among us used the Internet a dozen years ago? Probably very few, if any. But everyone reading this article today undoubtedly has some level of Internet connection (literally). This technological phenomenon has changed business in many ways and will do so forever. However, we cannot forget how fast technological change imparts radical changes in business.

Trade concerns. Trade creditors have often been the first to spot trouble. In several instances during the last recession, the paper trade was quick to identify printers in trouble. The trade learns that something isn't kosher through feedback from customers, employees, sales reps, other vendors, and other sources. As members of associations, these folks visit trade shows and share information with one another, as well as fuel gossip that may or may not be accurate. Remember when bankers would always get trade references?

Withholding taxes. There is something very specific to be learned in this area. Because we have transformed U.S. business from a manufacturing basis to a service based economy, we have higher reliance on high-priced workers. That translates into higher withholding taxes. Business owners with high payroll expenses often believe they can make up unpaid withholding taxes after they collect their receivables or when cash flow improves. Unless the company is going out of business and will be eliminating all payroll expense, payroll comes around again very quickly, and it is very difficult to make up for lost tax deposits. Furthermore, the IRS considers it stealing, since taxes are employee wages that are being entrusted to the business owner acting in a fiduciary capacity. That is why the IRS calls them trust funds. Unpaid withholding taxes have very onerous penalties. The IRS is not a lender, and unpaid taxes should not be considered an interest-free loan. Obviously, this is more than just a signal that money is tight and portends bigger problems for bankers with collateral issues that could be affected.