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Workouts: A Practical Alternative to Formal Bankruptcy Proceedings

Is your company teetering on the edge of bankruptcy? In the wake of the pandemic, many small businesses are suffering financial distress from inflation, labor shortages, rising interest rates, tighter credit and continued economic uncertainty. If your company is having trouble making ends meet, it may be time to devise a workout plan to avoid defaulting on your loans and filing for bankruptcy in court. Here are some tips to guide you through the process.

4 Warning Signs of Financial Distress

Financial problems rarely happen overnight. Early detection increases the chances of a successful turnaround. Here are four red flags to watch out for:

  1. Late financial statements. When financials are delayed, it could be a sign of management apathy, incompetence or denial. The CFO or controller may be hoping to turn things around in the interim.
  2. Mounting payables. Distressed businesses often fall behind on payments to suppliers and stretch out credit terms. Eventually, late payments may strain supplier relations and cause shortages. So, it’s imperative to catch and remedy payables problems as early as possible.
  3. High employee turnover. Employees are the first to know when a company isn’t meeting its goals. Late paychecks, idle machines and stressful work environments may entice workers — especially top performers — to seek greener pastures. As employees leave, morale and productivity often worsen.
  4. Cash flow problems. If a company reports a trend of negative (or erratic) cash flows from operations, it usually signals problems. Some troubled businesses try to stay afloat by selling off assets or by taking on excessive amounts of debt.

On the flip side, sometimes a company is in relatively good financial health, but its customers aren’t. And this can be a big problem if a key customer represents a substantial percentage of the business’s revenue. Be on the lookout for customers that are showing these signs of financial distress. If necessary, take steps to protect yourself from late or unpaid invoices — or from loss of future revenue in the event that a key customer goes out of business.

Estimate Liquidation Value

Liquidation value is an important benchmark for distressed businesses contemplating whether to opt for bankruptcy or a workout plan. There are two types of liquidation value:

  1. In an orderly liquidation, assets are sold piecemeal over a reasonable period to maximize proceeds.
  2. In a forced liquidation, assets are sold as quickly as possible, possibly at an auction.

Liquidation value often serves as a “floor” for business value. If liquidation value exceeds the value of the company as a viable going-concern entity, your business is probably worth more dead than alive. This benchmark also can help stakeholders evaluate the viability of purchase offers, management buyouts and reorganization plans.

A liquidation analysis starts with the company’s balance sheet. The book values of liabilities are generally accurate, but assets may require adjustment to estimate recoverability and current market values. It’s also important to consider the existence of unrecorded items (such as patents, trademarks, customer lists, IRS claims, warranties and pending lawsuits) and liquidation expenses (such as lease obligations, severance pay and professional fees).

Designate a CRO

You’ll need to assign one person to serve as the chief restructuring officer (CRO). This is a temporary position that’s charged with leading the rest of management through the workout plan. Independent external CRO candidates not only offer fresh ideas and experience, but they also add credibility to the plan.

The CRO’s initial charge is to create daily cash budgets. By taking control of cash disbursements, the CRO alleviates the imminent crisis, enabling management to chart an immediate course of action. The workout plan may include cost-cutting measures, asset sales and debt restructurings.

Create Short-Term Projections

Once daily cash flows are under control, the CRO should project cash flow for the next three to six months. These projections can help identify current sources and uses of cash — along with possible shortfalls. Then owners can brainstorm ways to bridge gaps (such as lines of credit or small business loans) and eliminate major drains on cash (such as unprofitable business segments or excessive overhead expenses).

One key area to focus on during recovery is collections. It’s critical to send bills out on time and follow up with customers once their payment deadlines have passed. No one likes making collection calls. But, if a customer has a serious problem, it’s better to find out as soon as possible and negotiate the best possible outcome.

Take Charge of Debt

Businesses with heavy debt loads may need help renegotiating their loan terms to facilitate an effective restructuring. For example, the CRO might request a lower interest rate, a longer amortization period or possibly even debt forgiveness. However, beware: Cancellation of debt may have tax consequences.

Another strategy is a debt-for-equity exchange, which is when a creditor replaces its debt with a percentage of ownership in the business. This solution could result in a surrender of company leadership, depending on how much control creditors gain. But the flip side is the prospect of future growth: Debt-for-equity frees up money that the business would have previously spent on debt repayment.

Coming to a debt agreement with creditors isn’t always possible. But it’s worth a try for businesses with strong working relationships with these parties, because it helps preserve the company’s credit rating and reputation.

Manage Business Essentials

Another proactive step toward recovery is closely monitoring operational functions. For instance, does the company’s accounting system provide the information needed to make effective day-to-day business decisions?

The system should generate weekly performance summaries that provide management with relevant, real-time information, allowing them to pivot based on changes in the marketplace. In addition, several major changes to the accounting rules in recent years may necessitate an accounting system upgrade.

Maintain Your Marketing Budget

A big mistake some struggling businesses make during economic downturns is to reduce spending on advertising and other marketing-related efforts. But if marketing expenses are cut too heavily, revenue could flatline.

Marketing personnel can help management develop new products and services or find market segments that haven’t been tapped into yet. However, don’t stray too far from your core competencies. For example, companies that specialize in business-to-business contracts might encounter challenges if they start selling directly to consumers or if they apply for government contracts.

Get Your Groove Back

Restructuring a business in today’s volatile market conditions is challenging. Contact your tax and financial advisors to develop a workout plan that suits your needs. Their professional expertise can help your business return to financial stability and build long-term value.