TMA Turnaround Management PDF

Body of Knowledge MANAGEMENT These review materials are not meant to be legal advice; they are merely intended to instruct professionals on the fundamental principles that should be known to operate in the turnaround and restructuring space. Compliance with any advice or guidance contained herein...

Body of Knowledge MANAGEMENT These review materials are not meant to be legal advice; they are merely intended to instruct professionals on the fundamental principles that should be known to operate in the turnaround and restructuring space. Compliance with any advice or guidance contained herein does not ensure compliance with any applicable law, rules, or other ethical requirements. If you have any legal or compliance questions, you should seek your own legal counsel. © Copyright 2017 Turnaround Management Association Table of Contents Body of Knowledge Management Lesson 1 4 Causes of Business Decline and Failure Lesson 2 18 Detecting Business Decline Lesson 3 24 Common Features of Troubled Companies Lesson 4 30 Characteristics and Roles of Effective Insolvency Professionals Lesson 5 38 Using Early Warning Signs Lesson 6 44 Basic Requirements for a Successful Turnaround Lesson 7 52 Turnaround Strategies Lesson 8 64 Development of a Turnaround Plan Lesson 9 82 Implementing the Turnaround Plan Lesson 10 106 When a Turnaround Is Not Possible Lesson 11 112 Stabilization Lesson 12 130 Ethics Resources 138 LESSON 1 Causes of Business Decline and Failure Rarely is there a single cause for a business’s financial decline or failure. Most often, it is a combination of events and conditions that coalesced to create a downward spiral of deteriorating performance, resulting in a financial crisis. While conditions and events can certainly transpire quickly, the underlying problems have typically existed for some time, making the company increasingly vulnerable to the financial stress it ultimately experiences. The success of any turnaround depends on an ability to navigate the company’s underperformance or crisis, an understanding of the origins of such conditions, and the impact of either appropriate or ineffective responses by management. Figure 1-1 Causes of Business Failure Bad Debts Loss of Market 10% 29% Competition 6% Other 13% Finance Management Failure 18% 24% This chart illustrates the most common causes of business failure. While management failure appears to be responsible for roughly a quarter of business failures, an argument can be made that, in hindsight, management either made or didn’t make the necessary decisions to take the company in the right direction. While there are undoubtedly external factors that can adversely impact a company’s performance, it is management’s responsibility to plan for such contingencies, and when faced with the contingent situation, timely and effectively execute the appropriate responses. Success also requires an ability to differentiate between the symptoms of trouble and the underlying causes. This differentiation is critical to accurately identifying the actual causes and taking the most effective corrective actions. Common symptoms, which can occur in combination, include: Financial Symptoms Deteriorating operating profits and margins Continuing losses Approaching or negative net worth  Cash flow surprises, including: -- Overdrafted bank accounts -- Loan requests for overadvances -- Limited or no availability on credit facilities -- Difficulty meeting payroll or other tax obligations -- Holding back vendor payments Violating a lender’s financial covenants Deteriorating or negative relationships with vendors or creditors Excessive year-end accounting adjustments or write-offs Failure to produce timely, accurate, and useful periodic financial statements Insufficient capital for investment in the company’s operations Lack of access to third-party capital Continually missing projected financial results Operating Symptoms Falling sales volume and/or market share Loss of key customers or contracts High turnover of key operating, executive or leadership employees Failed product launches Failed management information system implementations or conversions High chargebacks, returns, or allowances Low employee morale Low or declining levels of customer service Lack of a clear senior leadership succession strategy, or one that includes the succession of ill-equipped management Lack of reviewing Key Performance Indicators (KPIs) Inability to monitor or manage the drivers of Key Performance Indicators Resignations of Board members Ongoing shareholder disputes In the period leading up to and during a crisis, most attention focuses on combating these symptoms—that is, fighting fires. However, to return a company to stability and sustained profitability, the root causes of the symptoms must be explored. Generally speaking, financial stress can be classified between internal and external causes. 7 Internal Factors The majority of failures are generally attributable to internal causes as they predominantly originate from management that is either nonresponsive or nonconstructive in its actions. Poor Management Poor managers can create problems directly through dysfunctional behavior or poor decision-making, or passively through failure to identify changing market conditions, acting in a timely manner, or by being indecisive. Much attention is given to the differentiation between factors that can be controlled by company management and those that cannot. Management can often plan and position the company to address problems or react appropriately to unexpected circumstances. However, this is often easier said than done, given the continual demands of running and growing a business. Nevertheless, for every unsuccessful company, there are similar companies that exhibit resilience and succeed under the same or similar circumstances. Management leaders are usually intelligent and experienced. Their past successes in positions of increasing responsibility often drive their rise to the top. Yet the skills that made them successful in various roles do not necessarily translate into the skills necessary to lead and manage an organization. And even when they appear to have the necessary skills, they may exhibit other traits that impair or limit their effectiveness. Specific examples of ineffective management that, alone or in combination, can contribute to a business’s decline or failure include: Autocratic Management Style. An autocratic manager is unwilling to use or listen to advisors and reluctant to accept and adopt new ideas from subordinates and advisors. This is particularly common when leaders have experienced great success, and either dominate others by ignoring their input or simply insulating themselves from getting input from others. An autocratic style produces a culture that inhibits openness and constructive dissent. Lack of Management Depth. A manager who is threatened by subordinates with strong leadership skills is often surrounded by a relatively weak management team as the stronger managers will move on to other companies. Succession Plan. A weak manager will often fail to identify and communicate a clear succession plan for senior leadership. Subordinates of weak managers typically remain in positions for a long time and are not exposed to different functions and roles that could help them develop their leadership and problem-solving skills. Unbalanced Top Management Team. Without a diverse range of experiences and skills across disciplines, a management team can fail to identify important threats or opportunities as conditions change. Failure to Identify Changing Needs and Adapt Accordingly. Good management does not simply maintain the status quo, but rather navigates and encourages change. Many managers fail to grasp this and strive to maintain the status quo, particularly when they have experienced past success. This can lead to organizational inertia and analysis paralysis when significant challenges arise. Change is inevitable, and failing to see the need for change and properly reacting to it will ultimately erode a company’s financial success. Fundamental Lack of Understanding About the Company’s Customers or Markets. As tastes and products change, a company that fails to update and create products and services will not remain competitive. Creation and Sale of Products at Prices That Provide Insufficient Profit. Management often does not fully understand its overall or individual product cost structure, which will eventually lead to unprofitability. Fear of losing customers can result in a reluctance to increase prices. Furthermore, companies will keep unprofitable products to support a line of products or customers when the profitability from those products or customers continues to suffer. Failure to Identify and Continually Track Key Value Drivers. An inability to identify and continually track key production and profitability drivers leaves a business vulnerable to underperformance and decline. Lack of Focus. Members of management can become detracted from their core business when they go in search of additional profits or diversification of revenues. Worse, the core business can suffer irreparable harm if those new pursuits are unprofitable and use resources that should have been otherwise allocated. Slow or Hesitant Management Style. Managers who spend their time fighting fires or analyzing data instead of proactively and methodically working to solve problems lose opportunities and exacerbate the financial problems of the company. Chasing the Business Cycle. Companies enjoying success during an economic expansion often overextend and grow without considering the eventual decline in the business cycle. When the decline ultimately occurs, they become competitively disadvantaged, particularly if the expansion creates a cost structure with significant fixed costs. Lack of Market Vigilance. Successful management continually scans the market and remains vigilant for anomalies or trends that signal emerging changes and threats. Without this vigilance, it is difficult for a company to stay competitive. It is rare when a new condition is truly an unavoidable surprise; the signs are typically recognizable when actively looking for them. Broken Promises. Backing away from promises made to customers, vendors, creditors, and other stakeholders will result in a loss of confidence in management. It is acceptable to change expectations or assumptions as conditions change, but it is not warranted if the changes are necessitated by insufficient due diligence or lack of skill by management during the process that led to the original promise. Similarly, staying with bad promises, such as underpriced/unprofitable contracts, can do significant damage to the business. Misalignment of Compensation Incentives. When compensation plans are not aligned with the long-term strategy and economics of the business, they encourage behavior that runs counter to profitability or competitive goals. This can occur when a sales staff is incentivized to book new business that does not produce an adequate return or when a 9 CEO is incentivized to pursue short-term profitability goals at the expense of investment. Both diminish a company’s long-term competitiveness. Narrow Customer Base. Relying on very few or a single customer makes a business vulnerable to any relationship changes. The loss of a customer account could be catastrophic to the company. Even when the relationship is stable, the company can suffer because it will have little or no control over the sales terms, pricing, delivery, and other production terms. Overly Optimistic Outlook. Optimism can be a useful quality in a growing enterprise. However, excessive optimism can hurt confidence in a company’s management when outcomes don’t match those expectations. An overly optimistic outlook by management can be detrimental if it puts the company in a position to suffer economic losses when results fall short. Dishonesty and Fraud. Prevention is the best approach to dishonesty, particularly because it is difficult to combat directly. Only when dishonesty is identified can corrective action be taken. Proper management oversight and financial controls can be useful in preventing most fraud from irreparably harming a company. However, even if harmful acts are identified and prevented, the damage to a management’s reputation caused by the dishonesty or fraud can be significant. Ineffective Governance Board members are responsible for the oversight and overall strategy of a company, and typically, for the selection and oversight of the CEO. In addition, they should assist management with identifying key changes and risks in the business’s operating environment, plan for contingencies, and provide advice on the best ways to address these issues. However, many Boards lack sufficient independence from the CEO whom they are charged with overseeing and challenging. Characteristics of ineffective Boards include: Rubber-Stamp Attitude. Some Boards fail to provide critical review of actions by the company’s CEO and management. Combined CEO and Board Chairman Roles. In these cases, there is no true watchdog for the CEO, unless the rest of the Board can effectively step up to fill that role. Lack of Objective Perspective. A lack of outside directors deprives the company of objective perspectives. Lack of Participation. Directors who don’t actively participate in Board meetings or related discussions deny a company of potentially valuable perspectives. Unbalanced Skill Sets and Backgrounds. In much the same way that an unbalanced management team might miss important threats or opportunities, Boards that lack diverse and relevant skills and experience among their members can miss critical changes in the market or company. Lack of Communication and Accountability Among Board Members. Communication between Board members is as important as between the Board and management. Lack of Awareness of Corporate Duties. Board members, officers, and owners owe the duties of care, loyalty, and good faith to the company. Unaligned Interests. When Board members have interests that don’t align with corporate goals, conflicts can arise that need to be resolved in order to have an effectual Board. Weak Finance Function The finance function permeates every aspect of an organization, particularly as it relates to establishing financial controls, monitoring operations, and reporting results. When there are deficiencies in this function, the impact can be widespread and dramatic. Companies with an appreciation for the importance of finance will more readily incorporate the function into their management and control processes, thus reducing the risk of errors, omissions, and outright fraud. Common finance deficiencies can include: Inadequate Accounting Department. Accounting departments of distressed companies are often understaffed or staffed with underqualified employees who lack critical financial skill sets. This can result from a lack of understanding as to how important the finance function can be to a company, the desire to save money, retaining staff who were right for the company when it was smaller, or simply an area of the company that fell through the cracks. Inadequate Financial Controls. It is the responsibility of the CFO, and ultimately the Board, to ensure adequate controls are in place to preserve the value of the company’s assets, prevent fraud, and ensure the financial results are accurate, timely, and useful. Poor financial controls can put a company’s assets at risk and affect its viability as a going concern. The specific causes that, alone or in combination, can contribute to poor financial controls, and thus a weak finance function, include: Poorly designed controls over cash, receivables, inventory, and other assets of the company The lack of an effective costing system that accurately allocates fixed and variable costs so profitability can be accurately measured Inaccurate accounting information that makes it difficult for management to monitor activity and identify risks and opportunities Financial statements that are issued late, irregular reporting of key performance metrics, or a lack of financial and operating analysis Controls that are too centralized or reside too high up in the organizational structure and are not close enough to core operations Poor Working Capital Management. Working capital is defined as the difference between a company’s current assets and current liabilities. The largest elements of working capital are typically cash, accounts receivable, inventory, and accounts payable. To meet its financial obligations and support growth, a business requires cash to fund operations and purchase inventories, while at the same time continuing to service its payables and debt obligations. The financing to grow assets typically comes from increases in accounts payable, debt, or internal profits. 11 When there is enough working capital, a company can meet its obligations, take advantage of purchase discounts, and pay down debt to avoid additional interest charges. However, insufficient working capital can cause a company to increase its borrowing costs, pay extra for its inputs in the form of late fees and lost discounts, and violate its contractual agreements with its creditors. This can hurt its competitiveness if costs rise too much or promises to customers and vendors are broken due to delivery delays or late payments. Effective working capital management is critical for companies with long cash cycles, such as construction or government contractors. The cash cycle is defined as the length of time that a company ties up its cash while it procures inputs, produces a product or service, sells it, and ultimately collects payment from its customer. Proper working capital management can be a balancing act, and sometimes too much of a good thing can be harmful. For example, higher accounts receivable is generally thought of as being positive. However, if receivables are too high, the company does not have the use of the cash to pay its bills and operate. Large inventories can tie up significant cash resources while increasing the risk that portions of the inventory will become obsolete or damaged. Accounts payable is a source of funding, because by increasing accounts payable, a company keeps cash in the business. However, excessive levels can jeopardize relationships with vendors, leading to production disruptions and harm to the company’s reputation. Conversely, a level of accounts payable that is too low implies the company is paying its vendors too quickly and therefore not taking advantage of this interest-free funding source. Effectively managing working capital is integral to the control of cash and the ability to accurately forecast cash needs, particularly in a financially stressed situation. Balance Sheet Issues Excessive debt or overleverage. Excessive debt is a significant risk factor when a company becomes committed to allocating a significantly higher proportion of its cash flow to debt service. Any negative event or general economic downturn that reduces sales and cash could trigger violations of loan covenants, interfere with the servicing of debt, and create a cash crisis. Excessive debt can also cause the company to miss opportunities when current debt obligations prevent borrowing new funds for investment and growth opportunities. Insufficient or Inappropriate Debt Leverage. Using leverage reduces the need for either internally generated funds or further owner contributions. A balance between debt and equity will maximize the company’s ability to perform and earn yields on its equity. Excessive Fixed Assets. Fixed assets are intended to be used for a long period of time. If conditions change, rendering the assets no longer useful, their current value could fall well below the outstanding debt incurred to acquire them. This could cause violations of loan covenants associated with that debt, harm the company’s ability to borrow money, and potentially threaten insolvency if the loss of asset use becomes large enough. In addition, carrying a higher proportion of fixed assets can create an operating cost structure that is more fixed than variable, leaving the company more vulnerable to operating losses when sales levels decrease. When a company carries a higher level of fixed costs, it must maintain a higher level of sales activity to generate sufficient returns to cover them. Undercapitalization. The appropriate amount of equity for any company varies by industry, and shareholder equity as a percentage of total assets is often used for comparison purposes. While generally having more equity is better than less, debt allows the equity to earn a higher return on its investment as profits are spread over fewer equity dollars. Ill-Advised Finance Policies. While the decision to structure the company with excessive debt can make the business vulnerable to cash shortages and leave it with limited flexibility when additional debt is needed, an overly conservative finance policy can also cause damage. In an effort to conserve liquidity, capital expenditures may be reduced to the point that the cutbacks hurt the company’s production efficiency and long-term competitiveness. Sales terms that are too conservative may lead to lost sales and make the company’s products or services less attractive to its customers. High Operating Costs. If a company’s costs are relatively higher than its competitors, the result can be less profit to reinvest in production equipment, product development, and marketing, as well as reduce debt. This structural competitive disadvantage can be created in one or more ways, including: A relative cost disadvantage when the company is unable to take advantage of economies of scale A lack of knowledge as to more efficient operations A cost disadvantage when the company has little or no control over critical inputs, such as raw materials, access to less expensive labor, proprietary knowledge, or favorable locations Excessive allocations of corporate overhead to product cost due to a high-cost corporate structure Operating inefficiencies caused by insufficient capital expenditures and maintenance, poor plant layout, labor productivity, or management of those assets Operating Leverage. Operating leverage refers to the proportion of fixed costs versus variable costs in a company’s cost structure and the relative impact on profit given a change in sales. If a company has relatively high fixed costs, or high operating leverage, it requires more sales to cover its costs. However, it also earns more profit from incremental sales as the fixed costs are being spread over more units. On the other hand, it will suffer more from a drop in sales volume because each lost unit will reduce profit by a relatively larger amount. Poor Marketing Efforts. Ineffective marketing functions or a poor execution of a good campaign usually results in a decrease in profitability. Other problems include: Unresponsive or ineffective customer service A poorly trained sales force 13  Ineffective advertising A lack of focus on key customers or markets Insufficient new product development Lack of processes to measure effectiveness of advertising and marketing programs Excessive Growth. A business’s growth is considered excessive if afterward the company will be unable to meet its obligations that result, usually in the form of missed debt payments. Management sometimes seeks growth for growth’s sake. However, unless incremental sales are profitable, growth will ultimately create cash deficiencies. These problems can be larger and occur more quickly if the company is undercapitalized. Generally speaking, it is a financial advantage if growth is generated internally instead of through borrowing. Large-Size Projects. Management should not enter into any single project or contract that could cause the company’s demise if things go wrong. Similarly, a project that effects the entire organization, such as a computer system implementation or conversion, can have a severe impact if it does not go according to plan. Much can go wrong with large projects, including: Underestimating the costs, resources, and time Startup difficulties, such as inadequate training or a lack of available resources Significant capacity expansion in response to forecasted demand that does not materialize Entry into new and unproven markets that prove less profitable than expected Acquisitions. Acquisitions are similar to large projects, given the significant scope and execution risk of post-acquisition integration. The principal causes of failing to realize expected benefits from an acquisition include: Selecting a poor acquisition candidate that is not related to the current business and/or has no significant competitive advantage in its marketplace Overpaying for an acquisition Poor post-merger integration of people, processes and systems Promising acquisitions that are obtained at a good price often fail because inadequate attention and resources are dedicated to executing the integration after the acquisition. When the complications are significant and protracted, the diversion of resources and management attention can ultimately threaten the viability of the entire organization. External Factors External events that can adversely impact a company’s performance may occur slowly over time, such as changes in population or demographic makeup, or quickly, as with natural disasters. Some events might appear to be totally unpredictable and uncontrollable, such as strikes, environmental disasters or changes in government policies. Nevertheless, it is ultimately management’s responsibility to anticipate potential threats whenever possible and plan accordingly. External changes should be continually assessed and addressed so their impact can be avoided or mitigated with adequate preparation and an appropriate response. Categories include: Changes in Economic Conditions. To some extent, all businesses must cope with the ebb and flow of economic cycles. Even serious operating deficiencies can be hidden during periods of economic expansion and prosperity. However, these issues typically become illuminated and create significant difficulties during periods of economic decline. A company that is well-run during good times will be in a position to weather the bad times better than most, and may even prosper at the expense of its competitors. External economic challenges can arise with: Sustained reduction in demand Cost of raw materials Fuel costs Change in interest rates Change in inflation Decreasing credit availability Currency revaluations International monetary crises Adverse movements in commodity prices Overall local, national, or international economic downturns Unfavorable government policies that affect the company Competition. Approximately one-third of business failures can be attributed to competition, including loss of market share. Competitive threats take many forms, including: Price competition Entrance of new or foreign competitors Substitute products Industry consolidation 15  New technology Price competition is the most frequently encountered competitive dynamic. Companies routinely lower prices to gain market share for existing products or access into new markets. This is often encountered during periods of economic decline, as businesses attempt to maintain sales volume. In such cases, companies that are able to produce more efficiently and at a lower cost will be able to take advantage of the situation. Changes in Market Demand. In addition to the broader changes in the economic cycle, other trends and changing conditions can alter the competitive landscape, including changes in consumer preferences or tastes as well as broad cultural or societal changes. Many of these changes are secular in nature and can occur over long periods of time, such as demographic shifts, changes in lifestyle, or attitudes toward the environment. Some occur more quickly, as with demand driven by fads or popular culture. Those changes that occur gradually over time often go unrecognized and companies fail to identify and respond, consequently losing their competitive position. Management must continually monitor their market and adapt with changes to their products and services. Technological Changes and Other Factors. Technology has increased exponentially the degree and rate of change in all industries, driven primarily by information, communications, and transportation technology. It is hard to imagine a new strategy today without incorporating the role of the internet. Communication and transportation logistics effectively shrunk the world and vastly increased options for bringing products and services to a worldwide market. The effective use of information is critical in today’s marketplace. However, it is also increasingly difficult to achieve as management copes with both the large volume of data available and the usefulness and relevance of the information gleaned. Companies that cannot manage information and technology and use it to their advantage compete at a significant disadvantage. Regulatory Changes and Litigation. New or revised government regulations can affect every section of a company, including manufacturing, environmental, marketing, zoning, employment, banking, transportation, and intellectual property. Management needs to be aware of potential regulatory changes so they can possibly influence the new legislation or make plans for their own company if the proposed regulation is passed. Similarly, litigation can have a favorable or devastating effect on a company’s financial future, not only due to the outcome of the litigation, but also because of the time and costs involved in litigation. 17 LESSON 2 Detecting Business Decline Businesses typically do not fail overnight. Frequently, a failing business will go through a period of decline where the issues either are not timely addressed or the steps taken are insufficient. Once the problems compound, it can become too late for the company to avoid financial distress. Usually, these challenges can be recognized and classified into several categories and stages. Financial Statement Deterioration The first sign of decline is a modest deterioration of key components reported in the financial statements. Revenues decrease, margins compress, liquidity tightens, or leverage increases. The causes of this deterioration can vary significantly, but the result is the most recent financial period was not as strong as previous periods. Some of the factors causing the decline on the revenue side can be: Loss of a customer Increased competition Shifting market demand Changing technologies Poor customer service Changing sales prices Buying sales by lowering prices Loss or change in sales personnel Operational issues that lead to missed deliveries or quality problems In many industries, companies commonly have a significant portion of their revenue in a small number of programs or customers, a change in which can quickly lead to a significant decline in revenue. Trend Line Reversals. The first stage of decline appears when the revenue or profit trend line stops going up. Good managers adjust for the decline by finding new customers, cutting costs, developing new products, or entering new markets. In short, they adapt their business plan to meet the changing environment. Good managers understand the trends of their business and react appropriately. Weaker management teams tend to move slowly or act indecisively. Good managers recognize, acknowledge, and confront issues whereas weaker managers deny or ignore the issues and make excuses. Every business will have years during which they underperform. The key to returning to positive growth is how they respond to poorer performance and whether they are successful in implementing change. Once the initial decline continues into a second or third year, the company has a systemic problem and the following should be considered: How is the company performing compared to its industry? Is it benchmarking to their competition/peers? Is it continually missing projections? Is management surprised by the results? Declining or flat revenue is one trend to cause concern. Revenue decline can be the result of unit volume, pricing pressure, or both. Each factor should be analyzed and understood when looking for trends. Even increased revenue can hide an underlying problem, such as in retail when new stores hide the decline in same-store year-over-year sales. Gross margin and inventory valuations are two areas that need thorough analysis. Due to the way cost structures are accounted for, costs need to be analyzed at the product level in order to determine overall profitability. An indicator for companies lacking a strong grasp of their cost structure is frequent adjustments to either cost of goods sold or inventory. Unexpected Price Increases. Other items that cause decline in businesses are raw materials or labor prices. Companies that rely heavily on commodities are subject to price fluctuations, and their lack of ability to pass along price increases. Gold, oil, and steel have seen periods of huge changes in their price. The problem comes about when the company is not able to pass along the increased costs to their customers—or if the timing of the cash outflow is significantly earlier than the cash inflow from sales. Capital Investment. Another factor to watch is the amount of investment required to generate revenue. Some industries are very capital-intensive. Manufacturing requires machinery and equipment, hospitality requires land and buildings, and shipping requires boats/trains.) Other industries may require high-working capital requirements. For example, consumer finance companies must have the working capital required to acquire the loans they purchase. Software companies have countless hours in developing and writing software code before the first sale is made. Retailers and wholesalers have large stock inventories to meet their customers’ needs. Companies will also tend to hold onto inventory, believing the market will come back, or they don’t want to flood the market and offset their regular-priced inventory. Sometimes the market does come back, but more often the company is better served by moving that inventory and redeploying the cash elsewhere. The company with too much inventory is burdened, including holding costs associated with carrying obsolete inventory, or having to take a price reduction to move its inventory. Often, too much attention is focused on acquiring inventory at a good price and not enough on the cost of holding it. Poor Planning. For each of the above examples, there is a corresponding measure of efficiency, including: Inventory turnover Plant utilization Net interest margin Return on assets 21  Gross margin Bad debt as a percentage of accounts receivable Scrap or process waste On-time deliveries Days of sales of inventory on hand Cost of acquiring a customer Vacancy rates Watching how these key performance indicators (KPIs) track over time is critical for identifying trends and planning properly. No business is immune to cycles and trends that work for them and against them. The key is to see and understand the trends and adjust accordingly. Over-investing in assets can make a company inefficient when compared to its peer group because the company has larger inventory, more production equipment, more employees, higher overhead, bad debts, underutilized capacity, or other inefficiencies. The cost of the debt may reduce the company’s comparative profitability, reducing its ability to reinvest its profits. In good times or strong markets, these inefficiencies may not be an issue, but eventually conditions will accumulate and begin working against the company. Costs and interest expense increase, technology or consumer taste changes, or competition drives down selling prices. Something eventually happens that triggers an operational challenge. Companies that run efficiently have a better chance of adapting to the challenges and taking the steps necessary to overcome the adversities. Companies with growth prospects also have to plan for contingencies. They need to understand the costs of growth, capital required, and the potential challenges to successfully achieving that growth. The challenge can be growth that is more than the company can successfully handle financially, or the growth is not nearly as strong or as profitable as anticipated. Accounting Policies. Accounting policies can prop up earnings by allocating certain expenses to balance sheet items such as inventory versus the income statement and cost of goods sold. Some of the policies may include: 1. A depreciation amortization that expenses fixed assets on a longer schedule that the life of the asset 2. An inventory method, such as average cost or FIFO, that does not expense the most recent cost of inventory 3. Construction accounting that estimates the cost to completion 4. Inaccurate prepaid or accrued expenses 5. Aggressive policies to capitalize versus expense costs Growing Liabilities. Increasing liabilities is the most obvious signal of deteriorating conditions, whether it is accounts payable or debt. An analysis of accounts payable should include an aging report and a debt analysis should include a payment history. Debt vs. Capital Structure. Some companies are simply structured inappropriately. Many companies that are capital-intensive are financed with debt. Real estate, manufacturing, equipment leasing, and shipping are all industries that have huge investments in the assets that lenders are very willing to lend against, especially when the cash flow supports the underlying debt. A significant portion of these companies’ cash flow then goes toward debt service, which makes them very vulnerable to financial stress. Companies should match the term of their liabilities with the longevity of the assets that the debt is financing, so the cash inflow from the asset investment matches the cash outflow for servicing the debt. Using short-term debt to finance long-term assets will lead to potential cash shortages or a debt maturity that has to be refinanced. Prudent management would decide that if there is little to no margin for error because the debt levels are high, an inappropriate amount of risk is being taken. A good way to assess whether a highly leveraged company can survive downturns is to run various forecast scenarios and analyze the resulting cash flow projections and the ability to service debt obligations. Nonfinancial Factors. Not all factors pointing to the financial health of a company are financial in nature. Employee culture can be a good indication of how a company is performing. When a few employees are putting in long hours, it may indicate a lack of funds for additional staff or a gap in timely information going to management. On the other hand, when there are many employees who don’t seem to have a full day’s worth of work, it may be an indication of inattention on the part of management, which likely is being carried over into other areas of the company. The departure of senior management is another signal of problems within the company. Acquisitions can prove to be the downfall of a business. Companies often overstate the synergies of acquisitions, as well as underestimating the time and cost it will take to integrate the operations and realize the projected efficiencies. Upfront costs required for the integration can be overlooked and cause both financial and emotional stress. Another indicator of financial problems is quality issues. Companies with high scrap, process waste or other quality problems will be facing financial issues on several fronts, including higher costs, poor quality, warranty work, unhappy or lost customers, and lower employee morale. A major cost incurred is premium freight when parts or finished goods have to be shipped via overnight or expedited shipping. Each company is unique and has its own life cycle. The industry in which it operates, its culture, competitive position, and history are all part of the story. 23 LESSON 3 Common Features of Troubled Companies Troubled companies will display common internal and external warning signs. In reviewing these early warning signs, steps can be taken before the company faces serious financial stress. Internal Factors Communications Breakdown. Management tends to reduce its communication with employees, customers, vendors, lenders, and owners as the financial woes of the company increase. Unfortunately, this lack of communication can lead to its own set of problems as it creates confusion, distrust, and credibility issues, and prevents these other parties from participating in solutions. The ability to communicate to all stakeholders is vitally important during a financially stressed time in the life of a company. Indictors of a communications breakdown may include: Financial results are not communicated timely, internally and externally Information is provided slowly to lenders and other stakeholders Calls and inquiries from third parties are not being responded to CEO/president/CFO has retreated or resigned Business Plan Issues. Business plans are an integral part of a successful business. Operating without a business plan is equivalent to asking a management team to hit the bull’s-eye when there is no target. Indictors of business plan issues may include: Business plan does not exist Rumbling or feedback that the business plan is flawed or unachievable Company performance continually falls short of the plan Company philosophy and actions are significantly different from the plan Management’s financial incentives are linked to only specific components of the plan and not to the final, overall results Cash management becomes a primary focus versus growth and investment Excessive spending without measurable results Lack of capital investment in systems and operations to support the plan Employee Relations Issues. Company policies and senior management shortcomings can combine to create an environment where employees feel they have no ownership in the success of the company and consequently are simply going through the motions. Such issues could stem from lack of accountability, inability of the staff to influence management, and underlying disrespect of or mistrust between employees and managers. Indictors of employee relations issues may include: Labor problems, work stoppages, or persistent absences  Safety issues noted through excessively high workers’ compensation claims High employee turnover rates, especially in the financial area High number of open positions or the inability to fill positions Poorly constructed compensation and incentives plans Outdated organizational chart Managers acting in manner contrary to the good of the company Senior Management Issues. There is a learning curve associated with becoming a competent manager, and new management often does not have the background and skills to effectively manage, whether at the ownership or departmental level. A common example is when the best sales person is promoted to a management position, not only does the company lose its best sales person, but the skills needed for selling do not necessarily coincide with the skills needed for managing. Leading a company without internal controls and reliable metrics that report the pulse of the business is dangerous and can lead to financial problems. A professional manager will recognize the value of the various functions and be able assemble an infrastructure that is practical and appropriate for the business. Indications that the company has outgrown the capabilities of its senior management may include: Fragmented internal reporting Internal monitoring of business that is at too high of a level or too detailed to present an actionable course of action Ineffectual use of available data A lack of financial or operational metrics and monitoring systems Inadequate internal controls A lack of employee accountability and supervision Senior management is not hands-on or is ineffective Fraud is discovered or suspected Customer Issues. If the top line of any company declines, the company is at risk of severe financial instability. A company needs to be adept at reacting to revenue changes to ensure positive cash flow. Knowing what is needed to continue to enjoy current revenue levels is critical to a well-managed company. Indications the company may have customer issues include: Loss of a major customer or cancellation of significant orders/contracts High customer or accounts receivable concentration Uncollected accounts receivable, including where there are skipped payments within the aging report Payment default or bankruptcy of major customer 27  Delivery performance; poor customer performance metrics General customer dissatisfaction A customer service department that is stressed on a daily basis Inability to prepare a simple accounts receivable roll-forward report Excessive amounts of credit memos, returns, or warranty claims Vendor Issues. Current vendor issues can be a clear sign of future cash flow and liquidity issues. A trended, aging accounts payable listing will provide evidence that the company needs to stretch vendors and fails to generate sufficient working capital. In addition, a company that is no longer taking advantage of term discounts may be a sign of growing cash flow restrictions. It is important to understand how accounts payable is trending and how it relates to accounts receivable. It is difficult to manage working capital when the vendor trade has to be paid before the customers pay. A company that stretches its vendors consistently, faces supply cutoffs, pays COD, and has to purchase in smaller quantities is not generating sufficient cash. Communications with vendors is an important consideration in any financially stressful situation. Open and honest communication can produce good results and help a company avoid conditions that may spiral out of control. Indications of vendor issues may include: Vendors unwilling to advance additional credit Changes in key suppliers Excessively old or disputed accounts payable Account payable balances have been converted to notes payable A shift to COD payments Actual or threatened litigation for payment Bank and Lender Issues. A key source of financing and liquidity for many companies is through revolving or term debt. As a result, when a company begins to have issues with its lenders, it can quickly find itself in a situation where—despite generating revenue, having what seems to be a strong asset base, or generating net income—it may no longer have liquidity due to other factors resulting from its debt load. Indications of lender issues may include: Chronic overdrafts or overadvances An inability to service long-term debt Default interest rates Inability to refinance a note that is maturing Excessive negotiations to prevent covenant defaults or obtain waivers Loss of bonding (if applicable) Other Issues to Consider. Other considerations that can identify a financially troubled company include: Lack of management depth or succession plan Excessive time spent on daily cash management Poor production configuration Lack of preventative equipment and building maintenance Poor deployment of assets and unused capacity No or few investments in capital expenditures Underinsured assets Past-due payroll taxes Warning signs are the symptoms and not the causes of financial decline. It is incumbent on management to identify these signs and then drill down to the root causes. Once the root causes are identified, then corrective steps can be taken. External Factors In addition to evaluating the internal factors that affect troubled companies, understanding the client’s external environment can also provide warning signs as to the amount of financial trouble the company is in. Key external factors that influence a company’s business will help develop a perspective of the company in relationship to its financial situation. Each company will have its own set of external warning signs, but some of the common signs are: Excess or shrinkage in industry capacity Availability of supply chain components Global or domestic economic conditions Change in interest rates Shift in market tastes Unfavorable currency exchange rate Commodity pricing Offshore competition Government influences -- Public funding -- Changes in legislation -- Tariffs 29 LESSON 4 Characteristics and Roles of Effective Insolvency Professionals The role of an insolvency professional requires leadership, focus and skills that are very different from those used when working with a financially healthy company. In order to be influential and, ultimately, successful in maximizing enterprise value, insolvency professionals should exhibit proficiencies, including: Organizational skills Communication and negotiation skills Leadership and accountability Action orientation Ability to develop and maintain of a sense of urgency in others Creativity and vision Integrity and credibility Tact and patience Roles Insolvency professionals can wear a variety of hats. Most assignments will begin with being engaged as a financial advisor. The first task will be to conduct a situation analysis and develop the turnaround plan. The role of the insolvency professional may change as a result of the plan and analysis, perhaps becoming the Chief Restructuring Officer (CRO) with the powers and authority of a CEO. A CRO may be required where senior management positions have been vacated, stakeholders lose confidence in senior management, or senior management lacks turnaround skill sets and a more hands-on approach to the management of the business by the outside professional is necessary. Whenever possible, it is the insolvency professional’s job to lead the turnaround. This leadership may occur in the background or have a more visible role. While, in some cases, the insolvency professional will remain solely as a financial advisor throughout the assignment in some cases, in many instances the insolvency professional will be given more authority as he or she becomes more involved with the company. In addition to being the financial advisor, roles can include: CRO Interim CEO Interim CFO Receiver Examiner Chapter 7 or Chapter 11 Trustee Liquidating Trustee Assignee Alternately, insolvency professionals can take advisory roles to nondebtor parties, including: Individual creditors such as the secured lender Official committee of unsecured creditors Non-official creditors’ committees Equity holders’ committee Individual equity owners Board of directors Examiner Receiver Communication and Negotiation Skills Successful turnaround managers are very effective communicators, which is critical throughout the turnaround. It is the quality, not the quantity, of communication that is important to the stakeholders. When stakeholders do not receive communication, they are left to assume the worst and may take action that creates severe problems for the company. In a crisis situation, everyone is looking for the solution. While it is tempting, effective communication should not include preliminary, unsupportable solutions. The risk of communicating incomplete solutions is that, if the solutions are erroneous, the communicator’s credibility is greatly diminished. In this regard, the recommendations should always be based on cohesive logic that can be supported by empirical data. Communication and trust commonly break down during a crisis situation. Management is concerned with prematurely sharing negative information, and as a result, creates a situation where it is impossible to take corrective action and get the support of all the stakeholders. Most stakeholders, whether they are the lenders, unsecured trade, employees, or owners, are relieved when they realize an experienced person is heading the turnaround. Employees in particular embrace the opportunity to improve the business and will participate in developing a working strategy. It is important that communication with the various stakeholders is honest, open and direct. In addition, communication should be periodically updated, especially when the lack of an update will cause future credibility issues. Part of honest communication may include admitting that all the final answers are not available, but providing a current status report. The issue will become how much information is disseminated, as some information needs to remain confidential in order to not irreparably harm the business. While recognizing the need to avoid giving out confidential information or general information prematurely, the goal should be to: Communicate often Update any prior communications that have changed 33  Be as open and honest as the circumstances allow Be clear and direct Understand the message being communicated affects the personal lives of the people involved Leadership and Accountability Leadership is often confused with authority; they are not always the same. Leadership is the ability to influence people, often to persuade them to do things they would not otherwise be motivated to do. In any financially stressed situation, it is important to gain the cooperation of everyone involved. The core tenets of gaining influence consist of: Being genuine Listening carefully and respectfully Being rational in decision-making Being accessible, sometimes around the clock In crisis mode, shareholders, lenders, Board members, employees, customers, vendors, and union leaders look for direction and answers. Consequently, the insolvency professional must have general business acumen and experiences in a wide-ranging list of functional areas, including: Finance Accounting Risk management Information technology Corporate governance matters Taxes Legal and litigation matters Operations Sales Marketing Product development Strategy Business ethics Accountability means ensuring projects and objectives get done when they need to get done. Leaders must have a demonstrated track record of accountability, which proves they have been effective at organizing and implementing a turnaround plan. Key abilities include:  Devising a strategy and tactical plans based on facts and sound analysis Persuading key stakeholders to participate in implementation of the plans Delegating responsibility Securing proper authority for those tasked with an assignment Following up to ensure tasks are completed An effective insolvency professional should be directly responsible for and capable of accomplishing the turnaround. Sense of Urgency and Energy One of the most important ingredients to success is to engender a sense of urgency in the turnaround team. There needs to be a bias toward action rather than discussion. While it is not always possible to ascertain all the facts before making decisions, reasonable business judgments and decisions need to start being made as soon as practical. However, a sense of urgency needs to communicated in a fashion that does not give rise to panic across a client’s workforce. While time is certainly of the essence, fear and angst among the stakeholders will almost always be counterproductive. Moreover, the insolvency professional must have the energy and drive to navigate known and unforeseen challenges that come with a financially troubled company. Long days, fractious debates with internal and external constituents, and occasional setbacks are commonplace, and the insolvency professional will be expected to weather the vicissitudes of the process. Creativity and Vision Another key ingredient is the ability to forge a new vision for the company. This often requires creativity. Unconventional or even risky solutions may be required to achieve a particular objective. This places a high value on the ability to imagine and effect creative solutions, such as: Finding sources of cash Rearranging costs and fixed costs to other areas of the company Moving personnel around to better match their skills Finding unique solutions to gain key vendor or lender forbearance Creating a new routing plan to deliver products to customers Establishing strategic partnerships and joint ventures Creating new marketing strategies to increase revenues 35 Integrity and Credibility The importance of integrity and credibility cannot be overemphasized. A turnaround situation usually involves a company that is known to be in financial distress, and the various stakeholders are nervous and want to know how the company’s situation will ultimately affect them. The success of a turnaround plan will hinge on the insolvency professional’s integrity and credibility, without which the support needed for success will not exist. Not only is integrity and confidence needed internally within the company, but is needed with the outside constituents as well. It is not uncommon to work with the same outside parties in more than one project, and an insolvency professional’s reputation will carry over to other assignments. Insolvency professionals should always be mindful of their ability to competently perform every engagement. Limitations in scope and/or budget, highly specialized industries in which the insolvency professional lacks experience, and/or actual or perceived conflicts of interest should be thoroughly analyzed at the onset of any engagement opportunity to ensure the insolvency professional does not become involved in a situation that could lead to unwanted and embarrassing results for the company and tarnish the professional’s reputation. Services Offered by Turnaround Professionals In addition to leading a turnaround situation, turnaround professionals also provide additional services, including: Gather historical information and support for the turnaround plan Prepare budgets and schedules Review and make suggestions for operational issues Work with lenders and creditors regarding restructured terms Recommend personnel changes; terminate, interview, and hire employees Prepare rolling 13-week cash flows Prepare projected balance sheets, income statement, and statement of cash flows Provide debtor’s counsel with information needed to prepare the petition and Statements of Financial Activities (SOFAs) Provide necessary accounting services, including accounting policies and procedures Prepare U.S. Trustee’s Monthly Operating Reports (MORs) Perform any analysis of selected transactions to determine if preferences or fraudulent transfers exist Reconcile and evaluate creditors’ proofs of claims Determine or assist in determining the value of the business Assist in formulation and negotiations of a plan that meets the approval of creditors  Develop or assist in preparing the disclosure statement Assist company with refinancing or DIP financing Assist company with sale of company Prepare liquidation analysis Work for the creditors and other committees in a bankruptcy Work for the lender to assist in evaluating a customer’s turnaround situation Work for individual equity groups or the owners to evaluate a turnaround plan Act as receiver or assignee 37 LESSON 5 Using Early Warning Signs Every company experiences difficulties; it is how they handle these challenges that will determine the company’s future. Studying financial information and performing ratio analysis for early warning signs will enable a business to get a head start on improving its financial situation and avoid a full-blown crisis. Importance of Early Identification of Failure Most business declines are caused by management’s failure to adapt to internal and external changes on a timely and accurate basis. Ultimately, it is often a failure to react that derails companies as they face financial difficulties. Failure to react can stem from many problems: Financial information is not prepared on a timely basis Management does not review the financial information prepared The downward trend is thought to be seasonal or temporary There is a reason for the downward trend, and a solution is in mind or in process The methodologies used for preparing financial statements hide the downward trend information, such as using a FIFO inventory method The cost accounting system is inaccurate The financials are intentionally prepared to hide the trend Reacting will be admitting the company is in financial distress Reactions will require the support and knowledge of outside parties such as vendors, customers, bank, etc. Employee bonuses could be negatively affected The necessary changes are distasteful, and the preference is to avoid them as long as possible Fear employees will leave if the financial condition is disclosed Avoidance of admitting unsuccessful results All of that being said, early identification of potential financial decline is important, as the timing will impact the company’s ability to implement changes and recover. When early detection does not occur, the problem escalates beyond the initial causes: Management may become more hesitant to take the necessary steps as they become more invasive and drastic Solutions become more expensive Bankruptcy or liquidation may become the only options  Customers may leave for several reasons -- Customer service may have declined -- Product issues, including warranty claims -- Reluctance to rely on the company for future product or parts -- Distrust about getting accurate information as the company moves to solve its problems Vendor relations may deteriorate Banking relationships may become confrontational Negative cash flow may result and an inability to meet obligations as they become due Employees becoming concerned, work ethic declines, and employees leave When financial concerns first hit a company, most members of management have not previously experienced financial stress, and emotions often play a large part in how management initially reacts. Management could be embarrassed, unsure of next steps, confident a solution will present itself, fear of failure, etc. When working with members of management, it is important to understand their philosophy and emotional makeup so solutions can be derived that will be accepted and adopted. Lender Issues Due to reporting requirements and the lender’s own experience with other companies, the warning signs are often highlighted in the relationship with the lender. These would include: Chronic overdraft/overadvance situations Lack of accurate financial reporting Covenant violations Covenant default waivers Inability to service long-term debt Loss of bonding (if applicable) Ratios Financial ratios have many uses, such as investor analysis, internal metrics, and bank covenants, and are a quick method of highlighting problem areas of a business. They include: Liquidity analysis -- Current ratio -- Quick ratio Investment efficiency analysis -- Accounts receivable turnover -- Inventory turnover -- Accounts payable turnover 41  Operating efficiency -- Operating leverage Leverage measurements -- Total debt-to-equity ratio -- Primary secured debt-to-equity ratio Debt coverage metrics -- Interest coverage -- Fixed charge coverage -- Cash flow to long-term debt Profitability measures -- Return on equity Industry-specific measures include: Retail -- Revenues per square foot Transportation -- Cost per mile or ton Underpayment of Payroll Taxes Payroll taxes are often an immediate source of cash as it takes time for the nonpayment to be recognized by the governmental agencies. While this method of providing cash is quick and easy, it is not a prudent course of action. Government tax liens can not only trump other secured liens and trigger covenant defaults, but they become public record. In addition, individuals in the position to authorize cash disbursements can become personally liable for certain taxes, including the trust portion of payroll taxes, which are the amounts withheld from the employees’ paycheck. When immediate payment of these past-due taxes cannot be made, payment plans should be established and adhered to in order to avoid more consequential ramifications to the company, management, and employees. Declining Revenue Perhaps one of easiest early warning signs to identify is declining revenues. While most company managers know the reasons for the decline, the challenges include stopping or replacing the declining revenue and addressing the related costs and overhead that are no longer covered by the larger revenues. Liquidity Shortfall When the company lacks money to pay current obligations, the shortfall can manifest itself in: Bank overdrafts Payable checks written but held Longer outstanding accounts payable  Skipped monthly obligations Delay in replacing employees Delayed maintenance and repairs Fewer capital expenditures Nonpayment of payroll and other tax obligations Loss of Key Employees or High Turnover Employees will often give reasons for leaving that do not include the financial troubles of the company, partly out of loyalty to management and staff, guilt for being one of the first to leave, or simply not wanting to justify their decision. Therefore, the loss of key employees can be a creeping effect; it is not until the organizational chart is reviewed as a whole does it become clear there has been a significant exodus of key personnel due to the company’s declining financial health. 43 LESSON 6 Basic Requirements for a Successful Turnaround Successful turnarounds come in a variety of shapes, sizes, industries, and levels of distress. However, when assessing the probability for success and resulting longevity for a business in distress, there are certain issues that must be addressed. They require analysis, judgment, and decisive action in order for a turnaround to succeed. A turnaround is only possible when: There are one or more viable core businesses The company has the management and infrastructure resources capable of supporting a turnaround Management understands and accepts the underlying causes of the company’s financial difficulty Key stakeholders, including lenders, customers, and suppliers, have confidence in management and the recommended turnaround strategies There is adequate financing to support a turnaround The company has a dedicated person to lead the turnaround One or More Viable Core Businesses At the heart of every successful turnaround, there must be one or more viable core businesses. Sustainability is measured by the company’s ability to generate ongoing profits and positive cash flow over a long period of time. However, simply because a business or business unit is unprofitable and/or lacks positive cash flow does not necessarily mean it is not viable or can’t become viable. Ultimately, a business must have unique, strategic competitive advantages that ensure ongoing, long-term positive cash flow. Having a unique, strategic competitive advantage does not necessarily mean the business was the first to invent a particular product or service. Rather, it illustrates the customer’s desire to continue purchasing from a particular company instead of its competition. There are numerous examples of companies that were the first to market with a new product or service that eventually were not long-term viable. Uniqueness can be derived from a number of areas. For example, analysis of product, price, place, and promotion, can provide insight into a company’s potential competitive strengths: Unique product or service Lower customer pricing due to a lower cost structure Business locations Ability to use the internet for purchasing or sales Unique approach to the promotion of a product—including advertising, public relations, and sales promotion Any sustainable and unique, strategic advantage must result in ongoing positive cash flow. Depending upon the business, profitability is important, but accounting profits do not define long-term viability. A business must have ongoing positive cash flow, after debt service and unfinanced capital expenditures, to ensure its success. Viability may be enhanced or even restored, under the right conditions, provided the necessary action steps are implemented during the time available. Within the context of the turnaround process, viability is a function of three key measurements: 1. Positive cash flow, through analysis of cash receipts and disbursements 2. Liquidity, through analysis of working capital 3. Solvency, through analysis of the income statement and balance sheet Business and Personnel Infrastructure Assessing the business’s personnel, as well as its organizational structure, is vital to obtaining insight into the potential effectiveness of a proposed turnaround plan. The ability to institute change starts with having a team that is tasked with developing and implementing strategies. Without internal cooperation at all levels of the company, a turnaround plan will be difficult, if not impossible, to implement and complete. Some of the initial analysis that needs to be completed by the team includes: Whether there is alignment between the company’s overall business strategy and its organizational structure and size The opportunity to lower costs in its current configuration The strategy that will best suit the company, its capabilities, and customers going forward Cultural alignment is also a key to success, which relates to the current leadership roles, reporting lines, and financial systems and controls. Without a coherent working relationship, a turnaround plan may not be viable. Some considerations include: Key leadership and employees should be incentivized in a way that is consistent with short- and long-term goals Sales teams need to be compensated on achieving the bottom line, such as goals based on gross margins versus sales volume Production or manufacturing teams should be incentivized on cost or efficiency measures, such as less process waste or defects 47 Analysis Many, if not most, clients have more than one business activity. Frequently, more than one business activity is combined in the company’s financials. Each of these activities needs to be separated and the contribution margin, break-even, and location of each business analyzed separately. Client companies rarely know where they are making and losing money, primarily because their financial systems do not provide this type of information. Contribution Margin Contribution margin analysis is a fundamental building block of a broader break-even analysis. Contribution margin is defined as the difference between revenue and its variable costs, which is useful in determining the amount of margin being contributed to covering fixed costs and the profitability of individual products or services. To ensure viability, the company must, at a minimum, have a strategically important reason to keep any product or service with a negative contribution margin. For example, a company may need to offer a product with a negative contribution margin in order to offer a full product line. Even with positive contribution margins in all aspects of its business, a company may still be cash-flow negative due to its fixed-cost structure. Possible immediate responses to negative cash flow are: Reducing variable costs to increase the contribution margin Reducing fixed costs Reducing variable and fixed costs Increasing revenue, assuming the business has enough time and resources to implement the strategy At times, the most successful strategies to combat negative cash flow are those that include changes in each aspect of the business. Break-Even Analysis Break-even is the point where the revenue a business generates begins to produce a profit based on its variable and fixed cost structure. Once break-even has been reached, each incremental unit sold increases profit by the amount of its contribution margin, assuming the additional volume does not increase the fixed costs. A break-even analysis is only as good as the financial information used. The analysis of the financial records and observations of the company allow an understanding of the labor and overhead resources used by each business activity. The key issues addressed by the break-even analysis are: Which business activities produce a positive variable cost contribution margin The number of fixed costs covered by the contribution margin  The number of fixed costs that need to be reduced to reach break-even The activities with a negative contribution margin The formula to determine the break-even point is: Fixed Costs Break-Even Unit Volume = (Per Unit Selling Price – Per Unit Variable Costs) Break-Even Sales Dollars = Break-Even Per Unit Volume x Per Unit Selling Price A simple example is a company that has: Selling price of $1,000 per unit Variable costs of $800 per unit Fixed costs of $10,000 The break-even point is 50 units or $50,000 in sales, which means sales must exceed these volumes for the company to be profitable. Break-Even Unit Volume = $10,000 / ($1,000 - $800) = 50 units Break-Even Sales Dollars = 50 units x $1,000 = $50,000 Managers can use a break-even analysis to assist in pricing as well as determine profitability. Using the above example, where the break-even point is 50 units, if the price is decreased to $900 per unit, then 100 units must be sold to achieve break-even. Conversely, if the price is increased to $1,050, then company only needs to sell only 40 units to break even. Limitations to Contribution Margin and Break-Even Analysis While the contribution margin and break-even analysis are powerful tools, there are some limitations, which are based on the information and assumptions used in the analysis, such as when: The designation between fixed and variable costs is not clearly defined, which can lead to either variable or fixed costs being overstated or understated The allocation of shared costs between different areas of a company or different products can lead to different results Different selling prices for the same product can present challenges in determining the impact of a price increase or decrease. Seasonal or unpredictable sales volumes can skew the analysis The company has a significant fixed-cost structure, a contribution analysis has limited value, although a break-even analysis is still important. 49 Four-Wall Analysis A four-wall analysis is critical if the client has multiple locations that conduct similar business activities. Multiple retail sites are the prime example, but this analysis is also useful with many consulting and service providers. The four-wall analysis determines the contribution margin of the activities that occur within each location. Therefore, corporate overhead allocations are removed from the location’s cost when conducting this analysis. A four-wall analysis is conducted to determine which locations produce a positive contribution margin. The analysis can also model the combined contribution margin that would be available if the money-losing operations were closed and determine if this revised margin is capable of supporting the company’s fixed costs. If not, then the analysis shows the amount of fixed cost reduction that is needed based on the contribution margin available. Adequate Financing Bridge financing can provide the cash necessary to meet the business’s requirements until sustainable profitability is achieved. When possible, securing sufficient bridge financing early is recommended, as a later round of financing is often more onerous and difficult to obtain. There are multiple sources of bridge financing, and any of them can be equally effective, depending upon the circumstances. Bridge financing may be available from availability on borrowing-based and cash flow loans. Beacause incumbent lenders generally do not want their position related to collateral value to worsen, the company will need to demonstrate that the lender’s position is improved, or at least no worse, than its current position, and there are clear benefits to the lender by allowing the company to use its collateral for at least an agreed- upon period of time. A new third-party lender can provide financing, although it is generally more expensive than financing from the existing lender in terms of the interest rate and related fees. Additionally, this type of facility may contain warrants and/or convertible debt provisions. Collateral for third-party bridge loans could come from unpledged assets, if any exist, or from a second position on already-pledged assets. If the bridge loan has a second position, it will be subordinated to the existing loan agreement and will require the existing lender’s consent. Bridge financing can also come from the collection of cash from unusual sources, such as selling scrape, obsolete inventory, or underutilized assets. In addition, there are techniques that can be used to enhance cash and liquidity in the short and long term. Relationships with certain customers that are unprofitable and/or tie up excess working capital can be changed or terminated. Likewise, product lines and processes that do not generate cash flow or that require excess resources can often be re-engineered or eliminated. The key to success is to consider every realistic opportunity to obtain the cash required to finance the turnaround plan. Experienced Dedicated Person to Lead A final requirement is to have an experienced, dedicated person to lead the entire process, whether the ultimate outcome is a successful turnaround, sale of the company, bankruptcy proceeding, or a complete liquidation of the assets. 51 LESSON 7 Turnaround Strategies Tactical Versus Strategic It is difficult to for management to plan and implement a strategy for the company’s future when faced with daily operational and cash management issues. The most productive route for the outside professional is to learn as many of the issues and to get management’s input as soon as possible. This information and insight can help ensure that near-term suggestions and decisions will not impede the eventual recovery strategies. Depending upon the size of the company and the immediacy of the issues, this information gathering should happen as early as the first day of the assignment. The goal is to develop the strategy that best serves the company and its stakeholders, whether they are employees, owners, lenders, trade, or creditors. Unfortunately, a well- developed strategy takes time, knowledge of the business, understanding the concerns of the various stakeholders, and earning the cooperation of all parties. In the meantime, tactical issues and problems require resolution on a daily basis. A successful insolvency professional will balance the tactical decisions with the need for a long-term strategy so neither adversely affects a successful outcome. Requesting Financial Information When analyzing and assessing the true performance of a company, financial information needs to be gathered as the first step. Financial Statements, Budgets, and Cash Models Information requests center around financial reporting packages, including, but not limited to: Current balance sheet, income statement, and cash flow statements Prior years’ audited financial statements Budgets or forecasted financial statements and cash flows Management analysis of financial performance Accounts payable aging Accounts receivable aging Debt and lease agreements Real estate and equipment appraisals Compliance certificates Borrowing base certificates (if applicable) Bank collateral audits (if applicable) Materials previously compiled to sell the company or significant assets The initial analysis should concentrate on the trend in historical cash flow so as to be better able to prepare current cash flow analysis and projections. Traditional income statements reflect net income or income from operations, which does not necessarily correlate with cash flow. Noncash charges, working capital changes and capital expenditures must be considered in assessing the true cash performance of the company. Comparisons, such as showing the income statement as a percent of revenue or the balance sheet as a percent of total assets, will quickly identify areas that need further investigation. Declining gross profit margins will require additional analysis, as cost accounting systems do not reflect the cash needs of the company. In addition, expense allocations within a cost system may not be consistent with an analysis for turning around a financially troubled situation, and each cost should be analyzed objectively and not how it is classified within the cost accounting system. Understanding how the company captures its data, such as is information captured by product or product line, customer or geographically, line of business, division, etc. is critical to knowing how to use the information gathered. Also knowing when and how the company uses estimates is necessary to fully analyze the data. Studying the company’s budget and any comparisons of actual to budget will offer valuable insights. First, if a budget does not exist, it will indicate a lack of financial sophistication and fiscal responsibility. If there is a budget, knowledge gained from reviewing the budget would include: The level of financial depth management views as important Insight as to the reasonableness and thinking of management regarding the financial health of the company Insight as to the management style of the company (top-down or bottom-up budget preparation) An outline of management’s expectations A roadmap for analyzing a business (with the audit) A starting point for discussions with management as to the future of the company Specific problems and recent or unexpected changes in the business (when comparing to the actual) A starting point for an updated cash flow and operational budget When using financial information, spreadsheets, and calculations obtained from the company, independent verification of the information is necessary to ensure accuracy and an understanding of the financial data. 55 Increasing Revenues Almost every business owner and sales manager believes that if he can simply increase revenues, the financial concerns of the company will go away. However, by the time the company warrants an insolvency professional and turnaround plan, the time and resources needed to increase revenues probably no longer exist. Baring the truly exceptional situation, the insolvency professional should not start immediately with increasing revenues. Obviously, if price increases are a viable solution, they should be implemented, but not to the exclusion of other methods of improving cash flow and profitability. Deceasing Expenses The most immediate impact that can be made on a financially distressed company is to reduce expenses, as drastically and as soon as possible. However, the reduction needs to be part of a preliminary long-term plan. Understanding the business and the consequences of expense reductions is critical, along with a plan for addressing the issues that arise as a result of the cost reductions. Reducing expenses is important for several reasons, but there are pitfalls and the immediate result may be additional cash outflow versus cash savings. For example, when terminating employees, severance, vacation, and related payroll taxes need to be paid and can cause a significant cash drain on the company. Even though expenses such as vacation may have been accrued for financial statement purposes, the accrual does not provide cash. Replacing employees with less-expensive staff brings its own problems. First, there is the loss of the expertise and knowledge of the current employees. There is also the cost of hiring and training new employees. There tends to be higher turnover when a company is in financial trouble, especially if payroll checks have bounced. When hiring new employees, it is best to be as honest as possible about the company’s financial situation, especially with management-level employees. Using less-expensive raw materials in manufacturing may cause retooling issues or defective products. There is no doubt that reducing expenses is necessary for a successful turnaround. What makes the expense reduction successful is understanding where the problems will lie, taking the necessary steps, and providing an open communication so the process is completed as smoothly as possible. Business Focus The focus of the turnaround plan needs to be on the business, not on the owners, employees, financing sources, competitors or trade vendors. Implementing a successful turnaround will affect all of the stakeholders and, for at least the immediate future, in a negative way. Owners’ compensation and benefits will most likely be reduced, excess family members terminated, workforce reduced, union concessions made, payments to lenders and creditors stretched, customers disappointed, and often, an overall sense of “things are getting worse instead of better.” However, if the focus remains on the success of the business, the other constituents will eventually reap the rewards, which is the goal of the turnaround. Cutting Unprofitable Operations, Product Lines, and Customers Part of decreasing expenses is identifying unprofitable operations, product lines and customer relationships. By definition, a company that is facing financial difficulty lacks profitability in its business. Lack of profitability must be measured by the business as a whole, not by individual products or segments. The gross margin of a product is the difference between revenue and the actual costs to make that particular product or to service that customer. If the gross margin of a product or service is negative, it means the company is paying money out of its pocket to make that product or provide that service. Sometimes, this negative gross margin is intentional; for example, it may ensure a customer buys the rest of the line or encourages a customer to do business with the company. It can make sense to offer a product or service at a loss when creating a captive customer for replacement or input products, such as selling a copier to ensure the ink cartridge sales, or when an accounting firm prepares the owners’ tax returns at a significant discount in order to receive the corporate account. However, since the analysis behind these decisions was likely either never done or has become outdated, a fresh evaluation is encouraged. Determining which operations, products, or customers to eliminate is not a simple mathematical exercise. Even in the situation where the gross margin is negative and is not an inducement for additional business elsewhere in the company, there could be other reasons for deciding not to discontinue the product or service. The most common reason for continuing an unprofitable line is that the product or service is covering certain fixed overhead costs that would remain even with the termination of the product or service. Depreciation may be responsible for a product’s calculated book loss, but from a cash point of view, it is an overall contributor and should be kept, at least for the short term. The value of an insolvency professional performing this exercise is a fresh and unbiased view. It may be that the fixed costs can be shifted to another area of the company or eliminated altogether by terminating other, only slightly profitable, segments. The financial analysis must include a picture of the current structure of the company’s operations and the future financial projections incorporating the potential changes. While many long-term or hard-won relationships will be eliminated in order for the company to become profitable, it is critical that revenues and costs are allocated correctly within 57 the analysis to avoid unforeseen loss of revenues or increased costs in other areas of the company. Be particularly mindful of allocated costs, such as corporate overhead. On paper, it may show a certain division or product losing money, where in reality, it is covering a cost that will not be eliminated, but rather reallocated to the remaining segments of the company. Asset Redeployment When looking at ways to cut costs, also analyze whether assets can be redeployed for a better use, such as physical plants. An unprofitable manufacturing plant may become profitable by changing its use entirely or bringing in additional product lines. In addition to retaining and redeploying assets with the existing company, also examine whether certain assets can be sold and the proceeds better used within the company for the turnaround. Debt Restructuring and Relief Restructuring debt is possibly the single most important part of a restructuring effort. The turnaround path and the ultimate outcome can be determined by factors such as: The relationship of the company to its lenders. The amount and number of significant defaults Potential or actual changes in collateral value Lender’s motivation and desire to cooperate There are many options for restructuring debt obligations, both secured and unsecured. The insolvency professional must assess each option and determine which delivers greater advantage or impact with each strategic creditor or creditor body, and what effect those options will have on liquidity. When seeking debt relief, it is important to minimize fees and costs, such as forbearance or restructuring fees, field exams, appraisals, and legal fees. Where fees are required, the insolvency professional should negotiate rolling them into debt balances as opposed to paying up front whenever possible. Defining what is needed in the immediate term is a priority so the company can survive past the short-term difficulties. Many times, the current lender is only interested in the immediate future. The lender’s view is that the company should resolve its financial issues and become sufficiently profitable to service its debt, or take the necessary steps to reduce the debt, either by restructuring or liquidating. Therefore, while the company has to agree to certain conditions that may not make sense long term, they may make sense under the existing circumstances. By the time an insolvency professional is brought into a company, the lender may have increased the interest rates to the default interest rate, per the original loan agreements or a recent forbearance agreement. If at all possible, negotiating to accrue a portion, if not all, of the current interest payments will significantly help cash flow. It is usually easier to reduce or defer principal versus interest payments for the immediate future, particularly if it can be shown that the company will become financially stronger as a result of retaining this portion of its cash flow in the short term. The lender will not consider allowing the principal payments to be deferred if the money is being spent on expenses that do not lead to a better position for the lender. Often, another concession on the part of the lender is to reamortize the loan to either reduce the monthly payments or to extend the term of the loan. For instance, on a remaining 10-year loan, they may reduce the monthly payments for the next five years, and then increasing the last five years’ payments so that the loan matures at the same time. Alternately, they may take a 10-year loan and reamortize it on a 15-year schedule. Depending upon the lender and the current circumstances, they may either have the loan mature after 10 years with a balloon payment, or allow the company to renegotiate a 15- year maturity. When the loan is asset-based and the collateral supporting the loan is insufficient, causing an overadvance, the lender may be willing to reduce or eliminate the overadvance through other previously unacceptable measures, such as: Reducing or eliminating borrowing base reserves Reducing ineligible collateral Increasing advance rates Adding back in previously ineligible or undesirable collateral at reduced advance rates Adding the overadvance to another loan, such as an outstanding mortgage In certain circumstances, particularly with trade creditors, current payables can be converted to a note payable, to be paid on a schedule after the company has stabilized its cash flow. The advantages are the company does not have to meet these payable obligations while trying to restructure, and the vendor does not show outstanding receivables well over their terms. The vendor using its receivables as collateral for its lender obligations will still lose the receivable from its borrowing base. However, a current note receivable is a better asset on the vendor’s books than a long overdue trade receivable. Considering more unique opportunities, if there are related-party obligations or second tier loans, it may be possible to convert debt to equity. This is most likely when the parties are not going to be paid currently, and by converting to equity they share in the future upside of the company, without showing current defaults on their own balance sheets. While an unlikely solution with traditional lending sources, consider asking for reduced, deferred or no lender fees, and/or reducing the frequency of events that cause fees, such as bank exams, field audits or updated appraisals. As a company heads into financial trouble, the first trigger on a loan default is often tripping the technical or nonfinancial defaults of the loan agreement. For example, there may be requirement to have certain debt coverage ratios or working capital requirements, and while the company continues to make its payments, the lender has a loan on its books that is in default. There are several issues with being in default, even if only a technical or covenant default, the most important being the lender now has a defaulted loan for 59 its regulatory purposes. For the company, it usually means a default rate of interest, additional constraints from the lender, disclosures in financial statements and other negative impacts. If the lender believes the default is short-term and can be fixed, it may consider redefining or resetting the covenants as to eliminate the default conditions. DIP Lenders In companies where a bankruptcy filing is expected and significant liquidity issues exist, it is common for the company to seek Debtor-in-Possession (DIP) financing from the a senior, junior, or new lender. Even though the company is in bankruptcy, lenders are willing to make DIP loans because the loan will usually receive a super-priority lien on the debtor’s assets, making the DIP lender first in line to be paid. DIP lenders will often ask for a senior lien on all assets, which can extend to unencumbered assets and assets with an overall value in excess of existing financing. The loan agreement may include a number of onerous terms and conditions, which needs to be negotiated in order to maximize recovery to all creditors. It is typical for the required collateral and financing fees to be based on the line made available and not necessarily the amount borrowed, which needs to be taken into consideration when calculating the costs and cash need to service the debt. The amount of DIP financing should take into account the working capital needs of the company, estimated professional fees, and the amount of necessary to give assurance to the customers, vendors, and employees that the company will have sufficient funding available to complete their plans for exiting bankruptcy. Secured creditors are paid the value of their collateral. Often the collateral is sufficient to repay the lender, but on occasion the value, especially in a distressed situation, can be uncertain. Collateral, such as receivables, inventory, or real estate can decline rapidly, and it can be impacted by negative press or speculation, market or industry chan