It is essential that creditors, managers, and shareholders - as well as the attorneys who advise them - timely identify and respond to signs of a company’s financial distress. Financial distress, according to Investopedia, “is a condition in which a company or individual cannot generate revenue or income because it is unable to meet or cannot pay its financial obligations. This is generally due to high fixed costs, illiquid assets, or revenues sensitive to economic downturns.” Common signs of financial distress include negative or poor sales or profit growth; delays and defaults in paying creditors; increased costs of capital; and negative or breakeven cash flows. Failure to recognize such signs can imperil a company’s lenders, creditors, and/ or shareholders by leading to illiquidity, insolvency, and/or liquidation.
Financial distress is often evident from analyzing the company’s statement of cash flows (Statement). The Statement’s purpose is to directly and/or indirectly reflect cash receipts classified by major sources and cash payments classified by major uses (Financial Accounting Standards Board [FASB] Statement of Financial Accounting Concepts No. 5) - that is, from what sources is cash received, and for what purposes is cash used?
The Statement provides information on all cash receipts and disbursements, and noncash investing and financing activities during a period. The Statement reflects the changes in cash available compared to an income statement showing “profit,” whether or not that “profit” was collected in cash. A profitable company can be cash-starved due to poor collections and unable to generate enough cash to sustain ongoing operations.
FASB and the SEC require the State ment; even small, non-public companies must include the Statement within their annual financial statements (FASB Standard 95, subsequently codified in FASB ASC 230).
ASC 230 generally defines operating cash inflows as cash receipts from sales of goods or services; from returns on loans, other debt instruments of other entities, and equity securities; and from all other cash receipts that do not originate from transactions defined as investing or financing activities. Operating cash outflows are defined as cash payments to acquire raw materials for manufacture or products for resale; to other suppliers and employees for other products or services; to governments for taxes, duties, fines, and other fees or penalties; to lenders or other creditors for interest; to settle an asset retirement obligation; and all other cash payments that do not originate from transactions defined as investing or financing activities.
ASC 230 generally defines investing cash inflows as cash receipts from collections or sales of loans and debt instruments; from sales of equity instruments of other entities; from returns of investment in those instruments; from sales of property, plant and equipment; and from sales of loans that were not specifically acquired for resale. Investing cash outflows are cash disbursements for loans made and payments to acquire debt or equity instruments of other entities; and to acquire property, plant, and equipment.
ASC 230 generally defines financing cash inflows as proceeds from the issuance of equity instruments; proceeds from the issuance of bonds, mortgages, notes, and other short- or long-term borrowing; and proceeds received from derivative instruments that include financing elements at inception. Financing cash outflows are payments of dividends or other distributions to owners; repayments of principal amounts borrowed; and payments for debt issue costs.
Analysts evaluate cash flows from operations as indicative of a company’s cashgenerating capacity. To the extent that a company has healthy operating cash flows, the company is seen to possess the financial health to be able to internally finance future growth, repay debt, redeem its shares, and pay dividends. However, some managers use accounting shenanigans to exaggerate operating cash flows to mislead investors and creditors into a false sense of security about a company’s prospects.
Howard M. Schilit, Ph.D., CPA, a pioneer in the field of detecting accounting tricks in corporate financial reports, has written extensively about “accounting shenanigans” in annual financial statements. Dr. Schilit defines accounting shenanigans as actions taken by management that mislead investors about a company’s financial performance or economic health. He identifies the following four shenanigans that can mischaracterize cash Hows:
Analysis of the Statement should answer these questions:
Free cash flow is operating cash that a company generates after subtracting cash required to maintain or expand its asset base by investing in fixed assets. Free cash flow enables a company to pursue additional business opportunities that potentially will generate a return on invested capital. Negative free cash flow may indicate that the company may be making unusually large investments in capital assets for which not enough operating cash is generated to provide the financing. Negative free cash flows may also evidence financial distress since the shortfall will require either obtaining additional financing through the issuance of debt and/or equity or through the sale of fixed assets or assets held for investment.
Action steps to analyze a Statement to identify financial distress could include:
Not paying attention to the trends in a Statement could jeopardize a sound understanding of a company’s financial condition by missing early signs of financial distress. If these early signs are left unaddressed, they may develop into future financial distress to the detriment of a company’s lenders, creditors and /or shareholders from illiquidity, insolvency, and/or liquidation.
Michael D. Pakter CPA, CFF, CGMA, CFE, CVA, MAFF, CA, CIRA, CDBV, has more than 40 years of experience in accounting and forensic accounting, business economics and investigations in numerous industries and diverse engagements, including more than 20 years of experience in economic damages and business valuations. He has submitted expert reports in several jurisdictions and testified in arbitrations, regulatory proceedings and litigated disputes. State, Federal and Bankruptcy Courts, as well as arbitral bodies, have recognized him as an expert in accounting, financial analysis, forensic accounting, economic damages, business valuation and business economics.
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