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The Top 10 Warning Signs in a Business Return

By Linda Keith, CPA

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[Linda’s note: I updated this article June 2009 for our current economic conditions.]

In the good times, if you are a business owner or manager of a small- to mid-size business, you may have delegated ‘understanding’ of the financials to your accountant. You were busy making the business work and it was working pretty well.

The lenders kept renewing your operating line of credit. And you were confident that if there was something you should know, your accountant would point it out.

 
For the lenders, your tax return or financial statement software did the analysis. The financials were in the file and the collateral was favorable. Loan quality was good in general and loan volume seemed more the name of the game.

No longer. In this environment, we all need to step up our skills and knowledge to spot signs of trouble as early as possible. In this article, you’ll learn ten warning signs and understand how they have changed in this recession.

What kind of signs?

•    The business is in trouble in the income statement or the balance sheet
•    A lawsuit is in progress that could derail the company
•    The owner was getting set to retire and there is no successor in sight
•    The business is changing course either because of, or in spite of, the recession

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Business owner/managers and their CPAs need to know what the lenders are watching for now so you can anticipate their concerns. If you are the lender, watch for these signs and, if you see them, ask questions.

1. The owner is taking out more than the company can afford.

This may seem obvious…and that is why you need to be careful. There is nothing wrong with the owner taking out more than the company can afford on occasion.

There may have been a cash windfall because of the sale of an asset no longer needed, an insurance settlement or a one-time contract that won’t be repeated.

And when the lender projects cashflow, she leaves out nonrecurring income items that were available to boost owner take-home. I would take it home!

A lender will want to watch for the amount the owners are taking, but also the impact on liquidity and cash balances. And take a look at the liquidity in the owner/guarantor’s personal balance sheet. That will help determine if there is a problem.

A business owner/manager who is taking more in distributions or compensation than normal operations will cover needs to explain why to the lender…and show adequate liquidity in either the business or the personal financials, or both.

2. The owner is taking less out than the company can afford.

That almost seems counter-intuitive. Isn’t this a good thing? Maybe. But in most closely-held businesses, the company makes the money and the owners take it home. Period.

If the owners leave money on the table, it could be because the company is getting ready to expand significantly. Expansion periods tend to be riskier than stable periods.

On the other hand and in a down economy, it also may indicate a frugal owner who can live on less than his/her normal earnings and who is choosing to shore up the business. That does sound good.

3. Legal fees have increased dramatically.

This may mean a lawsuit is in progress. It also could be accounting or bookkeeping costs. Or perhaps other legal services such as intellectual property protection are in the works. Which is it?

If a lawsuit is in progress, the lender should focus on the likely and the worst future outcome. Can the company handle it?

A contract dispute in which the company will have to pay if they lose is not much of a problem if they can afford it. A product dispute in which they may lose the right to manufacture their best product is a problem.

Lawsuits and settlements happen in business. The important factor is whether they can handle the outcome. In a down economy, the business may be more vulnerable to lawsuits than usual.

Perhaps the biggest downside of a lawsuit right now could be the distraction it causes. It is hard to keep your eye on fighting through the recession when you are expending energy fighting off a lawsuit.

4. Discretionary expenses have dropped significantly.

A common short-term fix to problems is to cut back on costs. If repairs and maintenance has dropped dramatically when the business has not recently replaced older equipment, it is worth noticing.

I would start looking for a pattern with other costs…and for other signs of problems. It may be nothing. They may have done a lot of preventative maintenance last year, which is why this year’s cost is lower. Or they may be using under-utilized employees to pick up the slack on what is normally contracted maintenance work.

As with many warning signs, this ‘red flag’ may not really be red. Many businesses in a down economy take a close look at costs and find there are some they can cut back without harming the business. In fact, many say that coming out of a recession the ‘smart’ businesses will be running leaner because the recession caused them to reconsider their costs.

For example, what if insurance costs have dropped. Well, I am hoping you and I do not think of insurance as discretionary. But the amount of coverage might be. What if the business had not taken a close look at insurance coverage since they had closed several warehouses? The insurance may have been higher than usual, and it was a smart move to reduce it to the needed amount.

If you are the business owner/manager going in for a loan, take a good look at any costs that have dropped significantly, especially as a percentage of revenues. Be ready to explain to the lender why it happened.

5. Taxes and licenses do not seem to be sufficient given the wages paid.

Payroll taxes vary, but run between 10% and 40% of wages. It is a very quick check to compare 10% of wages to the figure in the taxes and licenses line.

Payroll taxes are only a part of the ‘Taxes and License’ line item on the return. If it does not even cover adequate payroll taxes, you may have a problem. Or they may have an overpayment rollover from a previous year.

If you are the lender, I can promise you that if you and the IRS are in line to get money from this business, you are not in front!

6. The owner is writing off significant, personal expenses.

Many people, including many lenders, think this is one of the ‘perks’ of being in business for yourself.  When it is blatant and excessive, it signals a willingness on the part of the business owner to mislead third parties (the IRS) for financial gain (less taxes).

The bank is a third party and the business wants money from the bank. Sounds like a third-party situation with the potential for financial gain to me.

There are groups of borrowers who are extremely aggressive in their tax returns. Commercial Real Estate developers and investors come to mind. A lender needs to know what is normal for her clientele. And a business owner needs to understand what it looks like to the lender when you appear to play fast and loose with the tax rules.

7. Cash reserves are low or have dropped.

While it is not apparent in a sole proprietorship (or a one-owner LLC filing Schedule C), the corporation and partnership returns include a balance sheet with information on beginning and ending cash. Watch for a significant drop or amounts that are not adequate.

With closely-held c-corporations, it is common for the liquidity to be low in the business because the owners take compensation out each year to bring the company to zero profit, often at the advice of their tax professional. And the owners of pass-through entities like LLCs, partnerships and s-corporations may not be focused on company liquidity if they are putting excess compensation or distributions in liquid assets they own personally.

If the guarantor’s personal balance sheet shows good liquidity and net worth, many commercial lenders either use that as a compensating factor or do a global analysis of both the business and the primary guarantor.

A lender can require minimum cash balances or other liquidity indicators as a condition of your loan. If the economy is down or the industry is challenged, you might expect dropping cash balances. Requesting more frequent financial statements is a good idea.

8. Their operating cycle is slowing down

As cash balances drop, a business becomes more vulnerable to the unexpected. And in a recession, there is more unexpected to cope with. Just as the business is trying to conserve cash and capture the cash they have coming as quickly as possible, their vendors and customers are doing the same.

This can result in cash being ‘tied up’ in the operating cycle for longer. Both business owner/managers and their lenders should be watching days in receivables, days in inventory and days in payables closely and take quick action if the ‘cash cycle’ starts to spread. The business may want to create a 13-week cash flow updated weekly to keep a close eye on the situation.

In many cases, the key is closer communications: between the business, its vendors and customers to be sure they are producing what their customers need and getting what they need from the vendors; between the business and its lenders to understand anticipate the cash needs of the company.

9. The business is selling off equipment that is critical to operations.

Check Form 4797 to see if there is a Gain or Loss on Disposal of Business Assets. Look at the business’ internal equipment list if you have access to it.

Consider if this is just the normal selling and replacing of equipment. If a business is selling off critical items and not replacing them, it may mean cashflow problems or a dramatic change in the business.

During a recession, some businesses may sell underutilized equipment with the plan to lease it when needed. This may be a very good move. Communications between the business owner/management and lenders is critical so that what is a good move does not look like a desperation play.

10 Ownership has changed.

For a corporation, the lender can check Schedule E, Compensation of Officers in the 1120 return. For a partnership return, look at k-1s if you have them or at Schedule B ‘Other Information’. One of the questions in that schedule is about distribution of property or a transfer of a partnership interest. You need a source other than the tax return for the same information on an S Corporation unless you have all the k-1s.

For closely held companies, continued success is tied closely to the experience of the owner/managers. Make it a practice to find out if the ownership/management has changed, even when the tax return you are reviewing is another business owned by the guarantors and not your primary business borrower.

In a recession, management history is even more important, especially if current management has successfully made it through a downturn before.

The Subtle Warning Signs may be the ones that sink you

So why did I not add dropping revenues to my list? Because I think you all will catch that one. This article addresses the more subtle warning signs.

Business owner/managers need to set up systems to catch these as early as possible. Work with your accountant to better understand and predict them. If you are putting in a loan request, address them.

Clearly, lenders need to watch for these, too. In most cases, they won’t kill a loan at the outset but will require the lender ask questions and understand the situation better before making a loan decision.

When credit is tight, each loan is tougher to put through for the business owner/manager and for the lender. Dealing with what could be warning signs up front will help smooth the way.


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