IDENTIFYING EARLY WARNING SIGNS OF TROUBLE IN A PROSPECTIVE BORROWER: The use of “Management Metrics” can make a crucial difference
By Gerald M. Sherman, David Brown and Eric Sweeney
Over the past several decades, considerable research hasbeen conducted into the causes of business distress and business failure. Many of these studies suggest that most severe business difficulties are rooted in non-financial issues, most particularly the practices and personalities of executive management and ownership. Despite this, albeit with much good reason, the process of considering new loans at both the banking and finance company level putslittle focus on assessing the management capabilities of a prospective borrower. This article will present a structured approach for going “beyond the numbers” to identify early warning signs of future financial difficulties by looking at seven management metrics. With consistent and thoughtful use, the metrics being presented should help improve the likelihood for spotting serious managementissues before the borrower’s results turn down significantly. Realistic strategies to address early warning signs of trouble, while still encouraging and supporting new business efforts, will also be suggested. In addition to being supported by academic research, a focus on management just makes good sense. Management makes the decisions that impact capital structure. Management makes the decisionsthat determine a company’s ability to produce efficiently. Management makes the decisions about what products and services to market and where to market them. Management leads – or doesn’t. The insights and methods being presented aren’t considered to be an even close to perfect method for identifying early warning signs. Rather, the intention is to provide a simple and realistic approach forlenders and lending managers to pro-actively identify issues of concern about management - at least some of the time. It’s also important to note that the observations and techniques being presented are intended to be applicable for medium and smaller sized borrowers with annual sales volumes of $250 million and under. Regardless, many of the comments will be equally relevant for larger companies.Today’s typical approach to evaluating new loan requests Commercial lenders review a prospective borrower’s financial statements and other financially oriented information which would usually include receivable and payable ageings; equipment, real estate and inventory appraisals; financial projections and
“business plans” prepared for future periods, etc. In addition, references may be checked,credit reports may be reviewed and some level of industry analysis might be undertaken. Needless to say, this is done to evaluate the current creditworthiness and future prospects of the borrower. Unquestionably, this overall approach is time tested and generally effective. At the same time, it’s important to point out that the ability of a prospective borrower’s management to deliver projectedfinancial results is typically assessed in a cursory manner - if at all. Further, any method used for assessing a management team’s capabilities is often applied inconsistently within the same bank or finance company.
Key limitations in the commercial lending environment Looking at today’s environment for generating new commercial and industrial loans of acceptable quality, there are severalfactors that should be acknowledged. First, commercial lenders, particularly those with substantial new business responsibility, are under severe pressure to maintain their productivity. Second, lenders with a focus on new business have to balance the credit worthiness of a prospective borrower with the need to win new business in a highly competitive environment. Third, lenders are experienced in...