15 RED FLAGS OF INCREASED CREDIT RISK
By William B. Creim

Last year one out of every seven businesses in the United States went bankrupt and closed. As profit margins are squeezed and companies become more desperate to move product out the door, the pressures on credit professionals are at an all time high.

Now as never before, a credit manager must recognize the “Red Flags” of risk in financial and accounting statements, and protect his or her company from new losses.

Every credit manager should watch for these “Red Flags” of credit risk:

1. “Consolidated” Financial Statements. More than one entity’s numbers are included. What are the numbers for your debtor?
2. “Pro Forma” Statements. Pro Forma statements do not follow GAAP standards. A typical pro forma statement puffs earnings and profits by excluding some negative information (losses, liabilities and/or change offs).
3. Big Sales/Profits in the Las Quarter of a Company’s Fiscal Year. Many businesses are seasonal, but big numbers in the last quarter may indicate inventory dumped at reduced prices, the booking of sales that are not really sales, or the artificial shifting of accounting numbers to “pump up” the bottom line.
4. Significant Increases in Unauthorized Deductions. A company can artificially reduce its costs for a short time period (and boost its paper earnings and profits) by increasing the unauthorized deductions it takes from its vendors.
5. Related Party Transactions. Intercompany sales and transfers can generate/manipulate sales, liability, asset and profitability numbers for the companies involved.
6. Management Complaints that its Publicly-Traded Stock is “undervalued.” When a debtor’s management unduly focuses on its stock price, it may be a warning sign that numerical and other information may become manipulated to “goose” the price of the debtor’s stock.
7. Pension Number Padding. More and more companies artificially “pump up” short-term profits by claiming gains from “overfunded” pension plans or by projecting overly optimistic future returns on a pension plan.
8. Big Rise in Inventory. When inventory rises faster than sales, trouble is brewing unless the increase makes sense for a seasonal business or a valid change in the business environment.
9. Big Drop in Inventory. A debtor experiencing cash flow problems or planning to file bankruptcy may reduce its inventory below its current sales level.
10. Unusual Turnover in Management/Accounting Personnel. When key Insiders and Outsiders are bailing out, you should be concerned.
11. Old Inventory Valued at Cost, Not Market
12. Old Receivables Still on the Books
13. Increase in Receivables Greater Than Increase in Sales. Booking cost overruns as “receivables” distorts a debtor’s receivables.
14. Guarantees and “Commitments” by the Debtor. All off-balance sheet liabilities need to be identified and evaluated.
15. Increase in Insider Sales of Stock and Stock Options. When the insiders are selling, it’s time to review your credit line.