Predicting failure: tell-tale signs and fatal combinations

Obviously, it is not advisable to extend credit to a company that is about to fail. The ability to predict business failure before the event has been the ‘holy grail’ of financial analysis for more than 50 years. Normally, there is a few years’ waiting before a business fails. A sudden and unexpected collapse is unusual.

Since the 1970’s increasingly sophisticated models have been developed to assist the prediction of failure. However, the following simple rules should not be neglected: 

Tell-tale signs

There are several signs that a business may be heading for difficulties:

·         It has only one product

·         It relies on a single customer or supplier

·         It is the only one in the sector showing profit improvement

·         It uses a small, unknown firm of auditors

·         The directors are leaving (or they are selling shares)

Fatal combinations

Identifying a number of uncomfortable factors in the annual accounts, should be taken as a warning sign. A business may:

·         be operating a depreciation policy that is out of line with other similar businesses, in order to produce profit

·         have negative operating cash-flow

·         have debt that is continually rising

·         have sale-and-lease-back agreements

·         have made a series of rights issues

Combine these with:

·         A low-quality board of directors, with little experience

·         Weak non-executive directors

The result will almost certainly be fatal!

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