Detecting Financial Problems
"At A Glance"

Suzanne M. Hopgood
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This article was published in the May 2002 edition of Director's Monthly, the newsletter of the National Association of Corporate Directors.

Ms. Hopgood is the President of the Hopgood Group, LLC, a turnaround company in Hartford, CT and a member of NACD.

She is the former CEO of Houlihan's Restaurant Group and the former CEO and Chairman of Furr's Restaurant Group (FRG).

 It is becoming increasingly important for Board Members to quickly understand the operations of their company and be active participants in its' future success. As a turnaround specialist, I am hired to reverse the direction of a company in crisis. I rely on acquiring and analyzing information quickly to develop goals and action steps.

In working with a firm, I look at a number of important non-financial indicators, including employee turnover (a negative indicator for culture, as well as a measure of the company's ability to deliver goods and/or services), brand identity (what the brand "promises" a customer and whether it is delivered), and corporate strategy with a focus on three to five years out. Seeing the company in action is also obviously important. Perhaps the easiest way to see how a company is doing, however, is to look at its financial statements.

The following financial information allows a quick and efficient orientation for the new board member and can also help directors understand what the issues and opportunities may be. It will take three to four days outside normal board meetings to review and understand the information outlined below

CASH FLOW STATEMENT

One of the most important documents is a cash flow statement with a breakdown of:

Income

  • Income itemized by each of the major revenue outlets
  • Extraordinary income such as the sale of an asset shown separately

By having the breakout of income, it will become instantly apparent if the company is obtaining a disporportionate percentage of its revenue outside its core business line, thereby masking serious issues.

It is important to understand the difference between what is showing on the balance sheet as cash and how much cash is available to pay bills or re-invest. In retail business for instance, much of the cash is in the individual stores' cash drawers. This does not represent free-and-clear cash to pay bills

Expenses

  • Normal company operating expenses. (Comparisons to industry averages provide a standard.)
  • Cash expenditures outside normal operating expenses such as:
    • debt payments
    • capital expenditures for new plant and equipment, shown on the dates the cash flows out. The cash flow schedule should match a capital expenditures schedule. Companies with sizable capital expenditures for plant and equipment should have a comprehensive schedule showing the contract signing date, when the liability occurs, and when the cash goes out to satisfy those liabilities.
    • cash outflows resulting from write-offs, which no longer show on the profit and loss statement but which are still regular cash outlays. (Closed stores will create this sort of liability.)
    • litigation liability, with a note as to when a settlement write-off may occur, along with the timing of any cash payments, and
    • any other extraordinary cash items.

EBITDA

EBITDA is the standard measurement of earnings and means Earnings Before Interest, Taxes, Depreciation, and Amortization. A reconciliation of EBITDA to cash provides a good measure of how earnings relate to actual cash flow.

A chart illustrating revenue, broken down by core businesses, over the past five years will provide the direction for sales. EBITDA, broken down by the same core businesses should be superimposed on the same chart. This will provide a clear illustration of what has happened to revenue and earnings for the last five years and the direction the company has been heading.

A chart showing revenue and the percentage of EBITDA for the last five years will illustrate how earnings relate to revenue. If an increase in revenue does not translate to an increase in earnings, there should be a solid explanation.

Corporate Culture.

Excessive employee turnover is a clear symptom of distress. Review the employee turnover in comparison to industry average for the past 3 - 5 years. This provides the trends in the company with a direct comparison to the industry as a whole.

Excessive turnover also creates a situation where no one knows how to run the business. When everyone is new they create their own systems and procedures. As this continues, the result is every unit running as a separate entity with its own rules. No longer are there consistent corporate policies and procedures.

Training becomes an extraordinary expense as the company is churning employees. Predictably, because vacant positions are a concern, the training period is reduced and the training programs compromised. This adds to the inconsistencies already existing in the company.

A company in trouble is a litigators dream. When extraordinary management turnover occurs, the policies and procedures governing labor, harassment, and discrimination regulations, are frequently not enforced. This in turn generates extensive and expensive litigation.

Lastly, long term employees who typically had pride in their positions and/or their division have usually resigned. Employee theft increases dramatically.

The Balance Sheet

Reviewing the balance sheet with the lead outside auditor and corporate council is next. Key points include:

  • underfunded pension liability
  • off-balance-sheet liabilities
  • control within the company
  • potential inpact/cost of litigation
  • any concerns that auditor/general counsel have.

Brand identity

The company's brand identity should be at the core of all strategic decisions. Understanding specifically what the brand "promises" the customer or guest is critical to understanding the company's operations since all decisions focus on meeting that "promise". If a company has neglected to provide the resources to maintain the company's "promise", request a tally with the cost of the human and capital resources necessary to erase those past due obligations. Deferred capital expenditures, insufficient R & D, insufficient customer feedback, inadequate employee compensation may all be symptoms of not meeting the brand promise. This analysis allows the board to understand the resources, human and capital, required for the company to "catch up".

The most important information comes from seeing the company in action. Observing how sales occur, the creation of the product or service, and its delivery is invaluable. Nothing replaces seeing how the company sells its product or service, creates it, delivers it to the customer, then verifies customer satisfaction.

Lastly, knowing where the company will be in three years and what the strategy is to get there is an important discussion to have with the CEO. Understanding the barriers to success that exist today and planning for future barriers is critical.

Reviewing the above information and having it updated periodically allows board members to quickly become comfortable with their role on the board, be able to make a meaningful contribution, remain current, and avoid some of the pitfalls that lead companies to become insolvent.
The Hopgood Group On-Line