Five Early Warning Signs

Is your bank’s lending officer asking you to invest more equity in your business, reduce your outstanding balance, or worse, find a new bank? 

If you answered “yes,” and it’s your first indication of trouble, you probably missed a few warning signs along the way. If you answered “no,” now is the time to learn about and look for these financial red flags. The sooner you recognize them, the more options you’ll have and the greater your ability to address them effectively. 

What are some of these early warning signs? They include slow or no growth, customer or market concentration, competing on price alone, shrinking gross margins and difficulty funding capital expenditures.

Slow or no growth: Not all growth is good, but slow or no growth in your business can be dangerous. Sure, many companies do just fine for years with limited growth. But what are the real underlying problems causing your business to slow down that sooner or later could cause a significant problem? For example, slow or no growth could be a sign of emerging threats or underlying weaknesses such as inferior products or services. It could be as basic as too few new or innovative products or services. It could also point to the presence of new substitutes—products or services that your previous customers find to be a better solution. Poor quality, late delivery, high prices, ineffective sales and marketing or weak economic or industry conditions also can be the root cause of your company’s slow decline.

There is no hard, fast rule, but companies should at least grow at a rate equal to the rate of inflation or their primary industry’s growth. Robust growth signals that your business is strong in terms of products and services, competition or competitive advantage, pricing power, sales and marketing, and customer loyalty or satisfaction. 

Customer or market concentration: Many small businesses were founded with the help of one large customer. In some cases, the customer prohibits its suppliers from doing business with its competitors. Most small businesses work hard to develop new customers over time, but find it difficult to grow their way out of a concentrated situation. Diversification helps to spread risk while concentration intensifies it. If one customer or market generates more than 15 to 20 percent of your sales, you need to start diversifying now. 

In some cases, a negative event associated with one or a few customers or markets can reflect negatively on your business, too. For example, industry recession, labor strikes or business failure can hit at any time. A change in corporate policy, such as minimum vendor size, may lead a dominant customer to take its business elsewhere. A customer or distributor might decide to become a competitor and take away valuable business. 

In other cases, the event may be less traumatic, and the damage may unfold over time. Your top customers might naturally soak up most of your company’s sales and marketing, engineering, and capital—leaving fewer resources for you to develop new markets, customers and products. In addition, large customers tend to continuously pressure suppliers to lower prices and make greater concessions. Over time, that shrinks your business margins. 

Competing on price alone: In his groundbreaking book “Competitive Advantage,” Michael Porter says above average performance in the long run is not based on price, but on sustainable competitive advantage. There are three basic types of competitive advantage: low cost, differentiation and focus. Many companies confuse low price with low cost or compete on price without an actual cost advantage. The sources of cost advantage include economies of scale, proprietary technology and preferential access to raw materials. Low prices without a cost advantage lead to low profit margins. Companies with exceptionally low margins are threatened by volume swings and tend to carry more debt than their peers.

Cost cannot be your only form of differentiation for long. Although cost leadership creates a competitive advantage, cost leaders must differentiate their companies in other ways to be above average or build a sustainable business. If they don’t, their competitors will.

Shrinking gross margins: Margin problems often start as pricing problems. Lack of a good cost accounting system and flawed pricing policies, strategies or enforcement are common contributors. But the failure to control costs or raise prices as costs increase can be devastating over time. This can happen when a customer changes product specifications or order quantities, when labor costs increase or when material costs increase.

Difficulty funding capital expenditures: High-performance companies reinvest profits in research and development as well as new equipment and technology. Some of this spending supports the development of new products or business opportunities. However, much of it is used to replace aging equipment with improved technology. At a minimum, companies should spend an amount equal to their depreciation. 

Companies that do not generate enough cash flow from operations to cover required capital expenditures either defer expenditures or take on more debt. In some cases, the bank will not lend more, which is a huge warning sign. At that point, the company is digging a hole that becomes difficult to climb out of.
Don’t wait for your lender or another stakeholder to tell you your financial condition is sending any of these five warning signs. Take the time to listen to, and analyze, your business’s condition. Make the tough decisions to change as needed. The sooner you start, the sooner you begin assuring a sustainable future for you business.

Matthew J. Miller is a managing director at BlueWater Partners, a middle market investment-banking firm. As strategic advisors to business owners and management, his firm works with companies to create, manage and realize business value, frequently before or through a sale or acquisition. BlueWater Partners’ services include advice on mergers and acquisitions, divestitures, capital sourcing, performance improvement, restructuring and turnaround. He can be contacted at: matt@bluewaterpartners.com.