Experienced lenders have a listing of red flags, or indicators of risk, when evaluating borrowers. Some lenders keep a list taped to their desk or on the computer desktop. Typical red flags include late delivery of financial information, turnover in the accounting and finance leadership roles, slow down in collection of AR, etc. Each lender has their own list of risk indicators that was developed based on their experience and training.
Now that it is 2.5 years past the Covid-19 lockdowns, are there new red flags to add to the list? Our experience says yes, there are two red flags to consider.
Disjointed Locations
The pandemic response ushered in remote work environments. While remote work was not possible for the production floors, it was possible for office staff. This has led to more staff members working remotely, which always reduces the interaction between and within departments. Even for positions that are seemingly easy to deal with remotely, the lack of interaction between departments can lead to problems. For example, an accounts payable clerk that is now working remotely lacks the accidental interaction with purchasing, logistics, or sales that can help with accounts payable management. Emails and texts can be substitutes, but they are partial substitutes.
In addition to the remote work, there has also been an increase in the number of offices and C-suite locations separate from the production floor. That trend had begun before the pandemic but it is more prevalent now. For example, production may be in one state, the C-suite 6 hours away in one direction, and the finance/accounting department spread over a location 6 hours opposite the C-suite. In another example, each executive officer is officed out of their homes located throughout the country, and there are multiple production locations. A quarterly in person meeting is not a substitute for effective daily in person interaction and management.
It will be important for lenders to monitor the remote work approach and the management versus production floor locations, as these factors may contribute to a weakened financial performance.
Inventory Levels
With the supply chain issues companies experienced in 2021/2022 we are seeing more problems with inventory management. In response to having difficulty receiving goods, companies responded in two ways – 1) they ordered more goods than before and 2) they also ordered what was available even if different than the core products.
Consumer habits were initially changed by the lock downs and remote work environments, and now are being impacted by returning to work and inflation. This means more companies have the wrong product for today’s demands, and more companies have too much product for their current run rates.
This has impacted companies ranging from sea food distributors, to the exercise industry, to consumer goods companies – and everything in between. We are seeing the supply chain stuffed from consumer to producer, with multiple steps in the process to consumer experiencing negative impacts.
We no longer can look at traditional indicators – inventory turnover, days sales invested in inventory, etc. We now expand our review to include turnover by SKU, turnover by customer, turnover by vendor, etc. Appraisers are becoming more data driven and there is downward pressure on valuations.
There is less forgiveness in the inventory levels. Working capital management is being stressed having to deal with past purchasing decisions and current economic environments.
Two New Red Flags
Just because a borrower is experiencing a disjointed work force or high inventory levels does not mean the borrower will be in financial trouble. But, we are seeing more companies that are experiencing financial performance problems traced back to these two new red flags. As with any red flag, it is an indicator of risk. We believe the physical locations of the work force and the level of inventory are two key indicators of risk as we end 2022 and move into 2023.
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